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Remarks by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the reception for the 100th anniversary of the Bank of Japan Representative Office in New York, New York, 6 January 2005.
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Toshihiko Fukui: 100th anniversary of the Bank of Japan’s presence in New York Remarks by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the reception for the 100th anniversary of the Bank of Japan Representative Office in New York, New York, 6 January 2005. * * * Distinguished guests, Chairman Greenspan, President Geithner, Ladies and Gentlemen, It is my great pleasure to welcome you to tonight’s event commemorating the 100th anniversary of the Bank of Japan’s presence in New York. Beginning of the Bank of Japan’s New York office In 1905, exactly one hundred years ago, the Bank opened its office here in New York. Its original mission was to oversee the business related to government debt issuance. At that time, Japan was engaged in warfare against Russia. Baron Korekiyo Takahashi, Deputy Governor of the Bank at the time, was asked to raise the necessary funds - 10 million pounds, between three to four percent of Japan’s GDP at the time abroad. He first went to London, then the largest financial market in the world. Since Japan was only a small emerging nation at that time, it comes as no surprise that Baron Takahashi could only raise half the necessary funds there. Fortunately, he came across a prominent American banker, head of Kuhn, Loeb & Co., who agreed to underwrite the remaining half. Baron Takahashi, who later became Governor of the Bank of Japan and eventually Prime Minister of Japan, wrote in his autobiography that he was utterly surprised by the fact that this American banker literally made the decision overnight. Even in those days, it appears, U.S. bankers had boldness and decisiveness when it came to completing a deal. Around the time the deal was struck, the yield spreads of the Imperial Japanese government debt over the British Consol, a measure of risk premium against the benchmark of the era, peaked around 300 basis points. It tightened to around 150 basis points one and a half year later. When the first official of our New York office arrived in 1905, he must have had a strong brew of cultural shock. For example, back in Tokyo street cars barely started to move on the ground; whereas in New York, subway service was already in its second year of operation. Also, I’m certain that he wasted no time in attending a Yankee game, whose history in New York started just two years earlier. The year 1905 was roughly half a century after the establishment of formal diplomatic relationship between the United States and Japan, and by then the number of Japanese citizens in New York had started to pick up. In fact, this place where we are all gathered tonight, the Nippon Club - which stands for Japan Club - will also be celebrating its 100th anniversary this year. Benefits from the presence in New York The New York market has continued to grow over the years. Time and again, Japan has benefited from financial activities in this market. Debt issuance following the Great Kanto Earthquake of 1923 is one such instance. When the deal was arranged, the Governor of the Bank at the time, Junnosuke Inoue, played an important role. It is interesting to note that his first hand knowledge of the New York market as well as the bonds he formed with U.S. bankers during his tenure as general manager of our New York office proved to be quite valuable for future endeavors. Equally significant has been the fact that, over the years, we have had the pleasure of engaging ourselves in countless discussions with such eminent figures as market participants, distinguished scholars, and especially the esteemed Federal Reserve officials, on topics ranging from monetary policy to financial market developments. On December 1913, the Federal Reserve Act was enacted, and the following year, the Federal Reserve Bank of New York came into existence. Through the discussions with the Fed, we have 7developed common understandings, such as: the importance of price stability for sustainable economic growth; the importance of a sound financial system as well as liquid and well functioning financial markets. Today, the primary responsibility of the New York office is to develop a channel for a candid dialogue with respectable people widely in the region it covers, that is, both North and South America, but the crucial part is of course the United States, above all, Federal Reserve officials and banking communities here. It is no exaggeration to say that New York office has been very successful in creating a bond of trust between us. This strong partnership has helped us weather a storm at times of difficulties. At times of no difficulties, too, our New York office gave essential inputs to discussions in Tokyo, thereby enabling us to learn a lot about not only the U.S. economy but also economic and financial developments in the world. Let me emphasize that our New York office is performing a very important role within the Bank of Japan. That is not just my personal view, but the entire Policy Board of the Bank appreciates the contribution made by the New York office. Looking ahead Before I conclude, allow me to briefly touch upon the current economic situation in Japan. The fundamentals of Japan’s economy have visibly improved during the past few years, although we have seen a temporary pause in growth in the first half of FY 2004. Considerable progress has been made in dealing with structural elements such as excessive capital stock, debt, and labor in the corporate sector, and the vulnerability in the financial system, all of which have delayed the recovery of the Japanese economy. Japan, it seems to me, is once again well poised to contribute positively to the world economy. Against this backdrop, the economic and financial ties between the United States and Japan remain as important as ever. On behalf of all the current and past colleagues of mine at the Bank, I would like to express my deepest gratitude for the unconditional support that has been extended to us over the years. I have no doubt that the coming decades will be no less rewarding than these 100 years have been. Thank you.
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Remarks by Mr Toshihiko Fukui, Governor of the Bank of Japan, at Japan Society, New York, 6 January 2005.
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Toshihiko Fukui: A tale of two cities in the eyes of a central banker Remarks by Mr Toshihiko Fukui, Governor of the Bank of Japan, at Japan Society, New York, 6 January 2005. * 1. * * Introductory remarks It is a pleasure to address this eminent audience of Japan Society. Before I proceed any further, I would like to offer my deepest condolences to all the people affected by the earthquake in Indonesia and the tsunamis that followed it. Though we are far away in New York from the tragic events in the Indian Ocean, I hope that we could do everything within our capacity to help our sisters and brothers in distress. Tsunami happens to be a word derived from Japanese, and Japan has in fact suffered from many tsunamis in the past. Though tsunamis are not necessarily made in Japan, I believe that we could share our experiences with the world. The purpose of my visit to New York in this frigid season is to commemorate the 100th anniversary of the Bank of Japan’s representative office. Some of you might feel disinclined to listen to me, as central bankers tend to harp on the same string. But I can assure you that my speech here will prove to be a lot warmer and more humane than the freezing air outside. Ladies and gentlemen, the world economy is in fact a lot warmer than a year ago. This is true of Japan’s economy too. Indeed, the fundamentals of Japan’s economy have visibly improved during the past few years. The basis for renewed momentum is emerging in both the corporate and financial sectors, putting the current recovery on a stronger footing than the last two recovery phases in the 1990s. The corporate sector has come a long way in its adjustment efforts to eliminate past excesses, and is working actively to devise new business strategies in this globally competitive environment. The financial sector, having made great strides in reducing non-performing loans (NPLs), seems better prepared to provide innovative services, going forward beyond this April when the blanket protection of deposits is removed. In a nutshell, Japan’s economy has virtually regained health that it lost a decade and a half ago. On the prices front, economic recovery has tended to slow deflation during the past few years. As productivity growth accelerates and unit labor cost (ULC) declines, however, linkages between economic growth and prices seem to be becoming a little tenuous in recent years. It is against this background that the core consumer price index is still registering a small decline in recent months, while the corporate goods price index is rising moderately. Under the present circumstances, the Bank of Japan has two tasks to achieve simultaneously: first, put Japan’s economy on a sustainable growth track by maximizing the new dynamism in our economy; and second, end deflation entirely. This is my New Year message to those who are particularly interested in Japan’s economy. As I said a few minutes ago, I have come to this city to commemorate the 100th anniversary of our New York office. I have learned that Japan Society will also mark its 100th anniversary in two years, meaning BOJ New York office and Japan Society are almost the same age. Actually, the general manager of our New York office 98 years ago - Mr. Eijiro Ono - was involved in organizing Japan Society. With this in mind, please allow me, for the moment, to talk about the early days of both Japan Society and the Bank of Japan’s New York office, that is, the early 20th century. Japan Society came into being in 1907 to promote friendly relations between our two nations. Many prominent leaders from both sides of the Pacific Ocean contributed to the establishment of this important forum. This was almost 50 years after Japan had opened its doors to the Western world, when Commodore Perry arrived on Japan’s shores to seek diplomatic relations between our countries. Japan Society was formed when our bilateral relationship was becoming closer, but sometimes tense due to the vagaries of international geopolitics in those days. As is often said, there was a bit of ambivalence in US-Japan relations. On the positive side, the United States was most helpful in guiding Japan towards successful modernization. We especially owed a great deal to US assistance in the process of industrialization. Trade linkages between the two countries were growing stronger year by year. At the same time, the downside of our deepening ties was emerging around the turn of the century. A rift appeared in parallel with the palpable increase in Japan’s military power in the Pacific and Japan’s surprising victory over Russia in 1905. Set against this backdrop, it was natural for the United States to see Japan as a rising power in Asia, with the potential to challenge US primacy in this geo-politically complex region. Japan Society was born out of this delicate international context. It was expected to perform a dual function - that is, cultivating a mutually beneficial relationship on the one hand, while preventing possible misunderstandings from developing into confrontations on the other. As I mentioned at the outset, the Bank of Japan was engaged in founding Japan Society. To say a few words on “pre-history,” the Russo-Japanese war (1904-05) prompted Japan to tap international capital markets to secure the war chest. As part of this effort, the Bank of Japan decided to station an executive auditor each in London (1904) and New York (1905), two international financial centers, to supervise the issuance of foreign currency sovereign debts of Japan. This marked the formal inception of our New York office. Since then the New York office has played a significant role in establishing solid relationships with the US financial authorities and banking communities. Japan Society saw its membership ballooning from 250 at the end of 1907 to over 1,300 at the end of the 1920s. But in the dark 1930s when military tensions between our two nations escalated, its activities were severely constrained. Similar hardship fell upon the Bank of Japan, leading up to the temporary closure of our New York operations in 1941, following the US government’s decision to put a freeze on Japan’s assets in America. Japan Society also virtually stopped activities in 1942. The rebirth of Japan Society following World War II began around 1946 and became active when Mr. John Rockefeller the 3rd became President in 1952. It is a testament to his foresight that he rebuilt Japan Society, which contributed greatly to bringing our bilateral relationship back on a viable path towards friendship and mutual respect. In a similar vein, the Bank of Japan re-opened its New York office in 1950. 2. Financial sectors in the US and Japan Having reflected on the history of Japan Society and the Bank of Japan, I am becoming more uncertain whether I am speaking as a central banker or simply as a friend of yours. Being a careered central banker, however, I should perhaps begin to focus on the developments that have taken place in the financial sectors of both our countries. It is often pointed out that Japan is different from the United States. This view is voiced not only in Japan but also in the United States. Some argue, again on both sides of the Pacific, that Japan is a unique country. I am always amused to hear it, because every country is different, and every country is unique in my opinion, just like everyone in this room is unique. There is always a Japanese way of business like there is an American way of business, a French way, an Italian way, and a Chinese way. In fact, such diversity makes the world very rich, in the same way as we enjoy Japanese food, Chinese food, French food, Italian food, and American hot dogs and hamburgers. As far as financial business is concerned, however, I think there are a number of similarities between Japan and the United States. By this, I mean not only a growing similarity in terms of financial businesses in recent years, but also plenty of similarities in terms of financial developments in history as well. I am referring to not just rosy episodes but also painful experiences. United States From the 1970s through the 1980s, the US financial system weathered several seismic difficulties. Failures of Franklin National Bank in 1974, Penn Square Bank in 1982, and Continental Illinois National Bank in 1984 are particularly memorable. The Latin American debt crisis in 1982 put enormous strains on US money center banks. Over-stretched investment boom was one of the culprits for the Savings & Loans (S&L) debacle in the late 1980s. In the wake of traumatic experiences in the 1970s and 1980s, the US regulatory framework was revamped to better prepare for future contingencies in the financial system. The enactment of the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991 marked a watershed in the regulatory context. In the 1990s, deregulation for financial business progressed, prompting large-scale consolidation among US financial institutions such as the mergers of Chemical Bank and Chase Manhattan Bank (1996), Travelers Group and Citicorp (1998) and Chase Manhattan Bank and JP Morgan (2000), to name just a few examples. According to a study by Finance Ministry and Central Bank Deputies of the Group of Ten (G10), the United States accounted for nearly 55% of the merger and acquisition (M&A) activities in the financial industry during the 1990s, centering heavily on the banking sector. This trend to consolidation continues in the 21st century. US banks’ stronger earnings and capital base have given a further boost to consolidation, including the creation of a financial colossus by JP Morgan Chase’s recent marriage with Bank One (2004). Primary motives behind the current wave of consolidation are revenue enhancement by synergy as well as its stability through product and geographic diversification, in addition to cost savings through economies of scale. Increased competition and stronger pressure from shareholders accentuate the urgency of revenue enhancement for many financial institutions. Japan Looking back on the past two decades, Japanese financial institutions have followed their US counterparts at least in terms of lending sprees. During the euphoric period of the mid- and late 1980s, Japanese banks expanded their balance sheets disproportionately, aided by sharp rises in share and real estate prices. Their aggressive investments overseas, particularly those in the United States, galvanized serious debate as to whether Japanese financial institutions would end up dominating the global financial landscape. It was in this period that a number of Japanese banks, including regional banks, rushed to New York to open up new offices. However, success tends to breed excess. The burst of speculative bubbles in the early 1990s left awful damages on the balance sheets of Japanese banks. At the same time, another adjustment pressure was imposed on the industrial side of Japan’s economy. That was a competitive pressure that the rapid industrialization of China and other Asian economies posed to labor-intensive industries in Japan. In other words, both lenders and borrowers were hard hit by these structural shocks to an unprecedented degree. This was the beginning of the abysmal spiral in which Japanese banks were trapped as an economic downturn and non-performing loans (NPLs) fed on each other. The bulk of NPLs forced a drastic shakeout of Japanese banks’ businesses, both domestic and international. I presume many of you still remember the “exodus” of Japanese banks from downtown New York in the late 1990s. This withdrawal en masse drove several famous Japanese restaurants in New York out of business, which was an international spill-over from the Japanese financial problems. After a decade-long hardship, however, a silver lining has finally emerged on Japan’s financial horizon. Progress has been made over the past years in resolving NPL problems. Structural adjustments in domestic industries seem to have run their course in view of the fact that a number of corporate businesses are posting record high profits, together with the lowest leverages during the past two decades. Improvements in corporate profitability and balance sheet adjustment have in turn enabled banks to reduce loan-loss provisioning. Being freed from “capital constraints,” Japanese banks are becoming more proactive in strengthening their viability through consolidation and strategic alliances. Consequently, the number of large city banks has dwindled from 9 to 4 during the past 4 years. Corporate culture in the banking industry is also undergoing a number of profound changes, as symbolized by the ongoing take-over bids for UFJ Bank by two rival mega-banks. Foreign capital has also played a meaningful role in this revitalization process. Carving out new business opportunities such as M&A advisory, distressed debt transactions and private wealth management, foreign financial institutions are providing the Japanese market place with good stimuli. Against this backdrop, Japanese banks and other financial services companies have begun to develop new business models, like providing a variety of non-conventional products and distribution channels that were unthinkable a decade ago, when the parochial turf war within the financial industry was all the more important. Japan and Asia With their non-performing asset problems receding, Japanese financial institutions are shifting their strategic focus to profit enhancement, including reinforcing their business outreach overseas. This change is especially notable in Asia where opportunities for new financial business are opening up saliently. A new economic dynamism is unfolding in the Asian region. I refer to the vertical division of production processes whereby Japan and the rest of Asia are becoming increasingly inter-dependent through the trade linkages based on their comparative advantages. In contrast to such close trade linkages, financial linkage in this area is still weak. As is widely known, however, Asia is abundant in both savings and investment opportunities. Linking savings with investment is the key role of finance. If savings are channeled into investments within the region, that will increase the scope of finance, thereby enhancing efficiency of capital allocation. In this regard, sharing closer time zones is a huge advantage for financial institutions in Asia. I hope that Japanese financial institutions will take advantage of this strategic potential to cultivate a new business horizon. The successful marriage of savings and investments within Asia will have global policy implications, too. The more efficient allocation of capital in Asia, the greater demand for goods and services in savings-rich Asia, and consequently the smaller imbalances in the global payment balances. Let me remind you that development of Asian economies has been made possible by its free access to the global market place, in particular US markets. This is evident not only by recent history of emerging economies but also by the history of Japan hundred years ago. Throughout history, not only consumers but also industries in the United States have benefited from growing trade and investment in Asia. Both the United States and Asia have therefore a common interest in keeping our economies open to international flows of goods and capital. I hope this economic reality will continue to provide a basis for US involvement in Asia, on which benefits accrue to all countries. At this juncture, let me add a few words about US-Japan relations by highlighting the fact that Japan is located at the west end of the Pacific Ocean, where the United States has a crucial stake. For this geographic reason, it is quite natural that Japan has long been the gateway for US engagement in Asia. I hope this will lay the groundwork for the plus-sum nexus of economy and finance between Asia, Japan and the United States. 3. Closing remarks Now, the clock tells me that I should conclude my speech. At the beginning of 2005, the US economy is growing steadily. Japan’s economy is regaining momentum after 13 years of stagnation. It is my pleasure to see our two economies expanding at this historic juncture, when both the Bank of Japan’s New York office and Japan Society are marking their centennials. I am sure this relationship between us will flourish for the next hundred years after we shared much wisdom in the preceding hundred years. Thank you very much for your attention and I wish you a very happy New Year.
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Speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, to the Naigai Josei Chousa Kai (Research Institute of Japan), Tokyo, 28 February 2005.
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Toshihiko Fukui: Toward sustainable economic recovery Speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, to the Naigai Josei Chousa Kai (Research Institute of Japan), Tokyo, 28 February 2005. * * * For Japan, this year is a crucial one, which may set the future direction of the country's economy. With the full removal of blanket deposit insurance scheduled for April 2005 now imminent, it is important to ensure that the financial system remains stable, the functioning of financial markets is further enhanced, and that the economy is brought firmly onto a sustainable growth track. Today, I will talk about the Bank of Japan's assessment of the economic and financial situation and the thinking behind its conduct of monetary policy. I. Recent economic developments The Bank releases its assessment of the economy as "The Bank's View" in the Monthly Report of Recent Economic and Financial Developments following discussions at Monetary Policy Meetings (MPMs). In "The Bank's View" for February, the Bank's assessment was that "Japan's economy continues a recovery trend, although there seem to be somewhat weak movements mainly in production." In other words, the economy is at a temporary pause: production has been weak reflecting exports, which have been more or less flat. Production in the IT-related sector has been weak due to continued inventory adjustment reflecting lower-than-expected growth in demand for digital appliances and the decline in global demand for PCs and mobile phones. In addition, production in the materials-related industry is lackluster, as spare production capacity is limited. For example, with the surge in demand, especially in exports to other Asian economies, steel and chemical industries have been producing close to full capacity and find it difficult to raise their production levels immediately. In the processing and assembly industries, such as automobiles, it has been reported that firms may not be able to increase production due to the limited availability of materials such as steel plates. Although these firms cannot increase production significantly, they have been able to raise profitability by expanding margins and improving productivity. Corporate profits are at high levels across most industries, although some IT-related firms have revised their profit forecasts downward. The ratio of current profits to sales in fiscal 2004 for firms of all sizes in all industries is likely to exceed not only the peaks recorded during the recovery phases of the 1990s but also the high point of the bubble period in the late 1980s. Given such improvements in corporate profits as well as a decline in structural adjustment pressures arising from excessive production capacity and debt, many firms are revising upward their business fixed investment plans for fiscal 2004. According to interviews with corporate management, firms seem likely to continue increasing business fixed investment in fiscal 2005. In the household sector, the employment situation continues to improve, and recently the figures for income appear to have bottomed out. Private consumption has been steady, although developments have lacked upward momentum due partly to adverse weather conditions. Adjustments in the IT-related sector are likely to be completed in or after spring 2005, while trend expansion of overseas economies, particularly the United States and China, is expected to continue. Against this background, Japan's economy will gradually emerge from its current temporary pause and move onto a sustainable growth path. II. Current economic situation in relation to the inventory cycle Some hold the view that the Bank's outlook for the economy is a little too optimistic. They maintain that, in the expansion and contraction of the business cycle, an economy which has lost its upward momentum will inevitably enter a downturn. These views focus on the short-term business cycle mainly caused by cyclical fluctuations in inventories. As the economy recovers, increases in product sales boost shipments, and thus cause inventories to decline. Firms then increase production to restore depleted inventories. However, if firms become bullish about the economic outlook and continue increasing production, at some point the pace of increase in production will exceed that of shipments and production will need to be curtailed to prevent inventories from accumulating. When shipments fall short of firms' projections, production will also need to be cut to reduce accumulated inventories. Although fluctuations in GDP caused by changes in firms' inventories tend to average out and so can generally be ignored, changes in inventory investment can be seen to have had a considerable impact on the business cycle in Japan, especially during periods of recession. During the past two recessions of 1997-98 and 2001-02, the fall in final demand caused substantial inventory accumulation, and the subsequent inventory adjustment placed strong downward pressure on the economy. Current inventory levels are, however, low, and few firms perceive their inventories to be in excess. The general background to this is that many firms continue to keep a tight lid on inventories so as to increase their balance-sheet efficiency. By industry, while inventory adjustment pressure remains in the IT-related sector, inventory conditions in the materials and machinery industries have actually tightened with firms in these industries unable to produce fast enough to meet increases in shipments. Inventory adjustment in the IT-related sector is expected to be relatively mild since IT-related manufacturers have promptly reduced their pace of production. In this situation, it is unlikely that inventory adjustment will cause the economy to deteriorate. III. Developments in overseas economies There have been periods when developments in external demand rather than domestic demand have posed greater downside risks to Japan's economy. For example, the Asian currency crisis of 1997 and the bursting of the IT bubble in 2001 had a considerable impact on Japan's economy. Business cycles across economies worldwide have become more closely correlated as globalization has progressed. In the recent recovery phase, uncertainty has attended the outlook for external demand due to factors such as the unpredictability of geopolitical developments and the surge in crude oil prices. Despite persistently high crude oil prices, there is less concern about the sustainability of overseas economic growth, and particularly the United States and China continue to expand steadily. In the United States, components of domestic private demand, such as household spending and business fixed investment, continue to increase, and the number of employees has been on an improving trend. Market attention has been focused on the sustainability of the U.S. twin deficits. The U.S. economy, however, seems unlikely to experience difficulty in financing its current account deficit for the time being, given that it continues to provide a high-growth, low-inflation environment and attractive opportunities for both domestic and foreign investors. Its fiscal deficit, the expansion of which is due partly to large-scale tax cuts, is expected to decline in line with the increase in tax revenues that will accompany the anticipated sustainable economic expansion. In China, overheating investment and an infrastructural bottleneck arising, for example, from the paucity of the electricity supply, are pointed out as potential sources of risk, and policy measures have been implemented to address these issues. Meanwhile, the Chinese economy continues to expand strongly, underpinned by firm domestic and foreign demand. These developments in overseas economies suggest that the associated downside risk is smaller than it was up to and including 2004. IV. Relationship between business cycles and structural problems It was thought that a greater degree of correlation between business cycles in economies worldwide would result in more volatile economic fluctuations. Recent economic fluctuations among major industrialized countries, however, seem to be displaying less volatility. The following are suggested as possible reasons for this: (1) changes in the economic structure which have resulted in a greater weight on less volatile components of demand such as consumption of services; (2) smaller fluctuations in the inventory cycle due to improved inventory management by firms; and (3) increased central bank credibility and the resulting stability of inflation expectations which have allowed central banks to avoid substantial tightenings of monetary policy that cause sharp economic downturns. In Japan, however, troughs in the two post-1990 recessions have been extremely deep. While these three factors have operated to some extent, excesses in production capacity, holdings of labor, and debts, along with the corresponding weakness in the financial system, have combined to place strong downward pressure on the economy. Structural adjustment has progressed considerably in the current recovery phase. As mentioned earlier, corporate profits are likely to exceed not only the peaks recorded during the past two economic recovery phases but also that recorded during the bubble period. Since firms' success in dealing with their structural problems is reflected in their profitability, firms are judged to be approaching the end of a prolonged adjustment phase. In this situation, the pace of decline in land prices, which was substantial, has started to slow. While land prices have continued to plunge in regional areas, specific parts of some metropolitan areas have experienced surging prices. Land price developments such as these, as well as the factors causing them, require monitoring. Turning to the financial system, considerable progress has been made toward restoring the system to soundness, particularly in dealing with the nonperforming-loan problem. Financial institutions have therefore been less concerned about the availability of liquidity. Under these circumstances, financial institutions have become less inclined to increase their current account balances at the Bank - a phenomenon reflected in undersubscription during the Bank's funds-supplying operations. Financial institutions are expected to continue further improving their business performance even after the full removal of blanket deposit insurance in April, as this will contribute both to the soundness and to the further revitalization of the financial system. The stronger the financial system, the easier it is for a virtuous cycle to operate, whereby improved profits and ongoing structural adjustment keep driving firms to even greater heights of activity. Economic fluctuations in Japan are also expected to exhibit less volatility, coming into line with the trend in other major industrialized countries. The economic environment in which Japan finds itself is basically robust: factors such as inventories, which can cause imbalances in the domestic economy, are currently insignificant; overseas economies are likely to continue expanding; and there has been progress in structural adjustments. The economy is likely to emerge from the current temporary pause and continue to recover. With time, the economic outlook visualized by the Bank will gradually take more concrete shape, as the economy moves more clearly onto a sustainable recovery path. V. Assessment of the decline in prices Japan's economy is experiencing its third recovery phase since the 1990s, during which period the Bank has been conducting an accommodative monetary policy. In the four years between 1991 and 1995, the official discount rate was cut from 6 percent to 0.5 percent (it currently stands at 0.1 percent). Faced with continuing weakness in the economy, however, and with prices still falling, the Bank embarked on the zero interest rate policy in 1999. Now, in a situation where short-term interest rates are constrained by the zero bound, the Bank is providing more ample liquidity to financial institutions through its "quantitative easing policy," and has made a commitment to continue with this policy until the year-on-year rate of change in the consumer price index (CPI; excluding fresh food, on a nationwide basis) registers zero percent or higher on a sustainable basis. By implementing drastic monetary easing, the Bank has sought to avert the risk that a vicious cycle, involving the translation of price declines into reduced corporate profits, depressed economic activity, and hence further price declines, could impair the monetary policy goal of price stability over the medium to long term. When general prices, which are the yardstick for evaluating individual prices, fluctuate on a large scale, households and firms have difficulty in accurately distinguishing a price fluctuation caused by changes in the supply and demand balance of an individual good/service from a fluctuation caused by a change in the general price level. This results in distortions in the efficient allocation of resources in the economy as well as increasing uncertainty about the future. Moreover, a decline in prices generates the following three problems. First, real wages adjust slowly when there is downward rigidity in nominal wages, and this impacts negatively on corporate profits and unemployment. Second, a rise in deflationary expectations produces an equivalent rise in real interest rates. Typically, nominal interest rates would be reduced to counteract this rise in real interest rates, but when an economy comes up against the zero bound on nominal interest rates, it is possible for real interest rates to rise above their optimal level and thus depress economic activity. Third, higher real interest rates and the fall in asset prices that tends to accompany a price decline cause financial institutions' asset quality to deteriorate. As these problems intensify, the operation of a negative cyclical mechanism between falling prices and declining economic activity generates significant costs for the macroeconomy. The Bank has continued to implement drastic monetary easing to prevent the economy from being caught up in this negative cyclical mechanism, i.e., from falling into a deflationary spiral. The year-onyear rate of change in the CPI, which had fallen for a time to as low as minus 1 percent, has recently recovered to around minus 0.2 to minus 0.3 percent in line with improvements in the output gap. A breakdown by components shows that the year-on-year rate of decline in the prices of goods, which are sensitive to economic developments, is gradually diminishing, and is currently at virtually zero percent. Excluding the effects of the rise in petroleum prices and the decline in rice prices and public utility charges, the pace of decline in the CPI is seen to be slowing moderately. The corporate goods price index continues to increase year on year, and the year-on-year rate of decline in the corporate service price index is diminishing. Various surveys also suggest that households' and firms' expectations for deflation, which have important implications for the economy, have been improving steadily since around 2001. In this situation, the problems arising from the downward rigidity of nominal wages and the zero bound on nominal interest rates are unlikely to be too serious, and the risk of a negative cyclical mechanism operating between falling prices and declining economic activity is therefore correspondingly small. In fact, the economy has been on a recovery trend in spite of the continuing decline of consumer prices year on year. This suggests that the current decline in prices is qualitatively very different from that experienced during 2001-02 when the fall in demand triggered anxiety about the economy falling into a deflationary spiral. VI. Effects of quantitative easing The economic and price conditions confronting a central bank change with time. Under normal circumstances, the role of monetary policy is to respond to these shifting phases by making the appropriate adjustments to the tightness/easiness of the monetary policy stance. Since June 2004, the U.S. Federal Open Market Committee has made six cautious 0.25 percent adjustments to the federal funds rate target, producing a cumulative rise of 1.5 percent. The Bank of Japan, however, has made a commitment, unprecedented in the history of central banks, to continue with the quantitative easing policy until the year-on-year rate of change in the CPI registers zero percent or higher on a sustainable basis. The Bank has made this commitment to prevent the economy from once again falling into a downward spiral in which falling prices and declining economic activity could be negatively reinforcing. This policy framework is expected to more strongly support private-sector activity as the economy recovers. Explaining this in a little more detail, the policy commitment to continue with the quantitative easing policy ensures that, even during phases of economic recovery, expectations of short-term interest rates remain stable as long as prices themselves are not rising. In terms of the current situation, this has allowed firms to continue to enjoy low funding costs. Firms are better able to take advantage of these lower interest rates to carry out forward-looking investment since they have been highly successful in their efforts to raise profitability. When firms are more confident about the future, a financial environment such as this makes it easy for them to raise necessary funds and execute their spending plans more aggressively. Yet when pursuing an unprecedented quantitative easing policy such as this, it does not do to be complacent about "excessive movements" - that is, phenomena which are not consistent with the sustainable growth of the economy. In the United States, low interest rates over a protracted period have generated remarkably high levels of liquidity. There is now discussion over whether this may be contributing to signs of potentially excessive risk taking, which seem to be reflected in relatively narrow credit spreads and the speculative demand becoming apparent in the housing market. Reduced credit spreads are a worldwide phenomenon, which is becoming slightly more marked in Japan than in other economies, and we cannot ignore the possibility that market participants have begun to take less notice of risk. Similarly, attention now needs to be paid to whether or not low long-term interest rates are consistent with the likely duration of accommodative monetary policy. It goes without saying that such matters will need to be taken duly into account in conducting monetary policy in the future. VII. Firms' positive commitments and their adaptability to change Even if some parts of the economy are moving forward aggressively, this is not to say that the whole economy is characterized by similar vigor. Some firms are starting to adopt a more positive stance as evident in the increase in business fixed investment. However, such cases are still limited, with a large number of firms placing priority on reducing interest-bearing liabilities by using their increased profits, and taking a "wait-and-see" attitude toward investment commitments. Although many firms are increasing business fixed investment, this is being kept within the limits of their cash flow. As pointed out earlier, firms have been cautious about increasing inventories during this recovery phase. The persistent decline in bank lending is also indicative of firms' hesitancy about making forward-looking commitments. Firms became concerned about business risk and financial risk management, having experienced highly volatile economic conditions during the 1990s and financial system instability during the second half of that decade. Their incentives to reduce interest-bearing liabilities and increase their capital bases as much as possible are therefore understandable. Expanding business lines is not so easy for firms in the current situation where, faced with price-sensitive consumers, they have difficulty in raising product prices in order to pass on the rise in materials and intermediate goods prices caused by the surge in commodity prices at home and abroad. There may also exist some concern about the impact of changes in the economic environment, such as those caused by the low birth rate and rapidly aging society. However, corporate management will not continue to appeal to uncertainty about the economic outlook to justify its hesitancy in making positive commitments for long. Amid rapidly changing technology and increasing competition, firms know that they need to maintain high profitability in the medium term by continuously and swiftly reallocating their management resources while continuing to invest in highly profitable areas. The economic environment surrounding firms is now well suited to encourage such commitments. In the labor market, deregulation and changes in people's attitudes and lifestyles have combined with firms' need to adapt to changes in the industrial structure and to improve profitability, with the result that the number of non-regular employees has increased. Although indicative of firms' unwillingness to commit themselves to hiring longer-term regular employees, such developments, in so far as they illustrate the increased flexibility of the labor market, also suggest that firms have become better able to adapt to change. In addition, some firms have started to invest in highly profitable areas. They have been studying consumer needs so as to provide attractive new products and new services, and this has contributed greatly to private consumption, which has continued to be firm despite sluggish growth in income. A breakdown by household spending behavior shows that spending is increasing in a wide range of areas; these include travel both within Japan and abroad, education geared toward lifelong learning and self-improvement, and health- and sports-related services. The evidence suggests that firms' efforts in various areas have been gradually bearing fruit. Furthermore, there are signs that the effects of monetary easing have been feeding through into the corporate financing situation. In the December Tankan (Short-Term Economic Survey of Enterprises in Japan), the number of firms that perceived financial institutions' lending attitudes as "accommodative" exceeded those that perceived them as "severe," even among small firms. In such a setting, firms will be more likely to use their free cash flow, not to pay down debts, but to increase business fixed investment and financing for other research or investments aimed at increasing growth. Alternatively, they may prefer to buy back their own stock or increase dividend payments. Gradually, more firms will start to make use of the accommodative financial environment to raise funds in the markets and execute more aggressive spending plans. As the economy achieves a balanced recovery path, this kind of positive forward-looking behavior should become more widespread. Meanwhile, financial institutions are making more efficient use of their capital to devise new financial services that more closely meet the needs of firms and households. At the same time, they are maintaining efforts to further enhance their risk management and increase profitability by adopting new financial engineering techniques, as well as by making better use of financial markets. As the efforts of industries and financial institutions combine and reinforce one another, the economy will escape the current confines of the short-term business cycle and enjoy longer periods of sustainable recovery. The Bank will continue to conduct monetary policy so as to offer vigorous support for the positive efforts being made by the private sector.
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Statement by Mr Toshihiko Fukui, Governor of the Bank of Japan, concerning the Bank¿s Semiannual Report on Currency and Monetary Control, before the Committee on Financial Affairs, House of Councillors, Tokyo, 31 March 2005.
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Toshihiko Fukui: A review of the Bank of Japan’s conduct of monetary policy Statement by Mr Toshihiko Fukui, Governor of the Bank of Japan, concerning the Bank’s Semiannual Report on Currency and Monetary Control, before the Committee on Financial Affairs, House of Councillors, Tokyo, 31 March 2005. * * * Introduction The Bank of Japan submitted its Semiannual Report on Currency and Monetary Control for the first half of fiscal 2004 to the Diet in December 2004. I am pleased to have this opportunity to present an overall review of the Bank’s conduct of monetary policy. I. Developments in Japan’s economy Japan’s economy is still at a pause due to such factors as the ongoing adjustment in the production and inventory of IT-related goods. The underlying mechanism for economic recovery, however, continues to operate steadily and production, which was somewhat weak some time ago, has been more or less flat recently. The economy is therefore expected to emerge from this pause before long and to continue recovering and move to a sustainable growth path. In more detail, overseas economies, particularly those of the United States and China, are expected to continue to be on an expanding trend. Adjustment in IT-related goods is likely to be completed before long, partly because manufacturers started adjustments at an early stage while demand was increasing. In light of this, exports and production are expected to increase. Corporate profits and business fixed investment are expected to remain on an increasing trend, as structural adjustment pressure stemming from firms’ excess capacity and debt has been easing. In addition, household income has clearly stopped declining while the employment situation continues to be on an improving trend. Private consumption, therefore, is expected to show signs of a gradual increase. Attention should, however, continue to be paid to developments in IT-related demand and crude oil prices, which have been at high levels recently, and their impact on the domestic as well as overseas economies. On the price front, domestic corporate goods prices had been rising since the beginning of 2004, but they have been somewhat weak recently. As for the outlook, they are likely to become relatively strong again, due to the rise in the prices of crude oil and other commodities at home and abroad. Consumer prices (excluding fresh food, on a nationwide basis) continue to fall slightly on a year-on-year basis in a situation where they have been less responsive to the economic recovery, reflecting the increase in productivity and the restraint on labor costs by firms. Slight year-on-year falls in consumer prices are expected to continue for the time being, partly due to such factors as the effects of the reduction in electricity and telephone charges accompanying deregulation. The money market remains stable overall against the background of the Bank’s provision of ample liquidity. The full removal of blanket deposit insurance is scheduled for April 1, 2005. Concerns about the financial system have decreased significantly as financial institutions have made progress in regaining financial health. Financial institutions have been more confident in raising funds in the money market and their liquidity demand has decreased, as implied by the fact that, in the Bank’s funds-supplying operations, there were cases where bids fell short of the Bank’s offers. In the capital markets, stock prices have been firm on the whole. Long-term interest rates have been generally stable, although there was a temporary rise. The environment for corporate finance is becoming more accommodative on the whole. The lending attitude of financial institutions is becoming more accommodative, and their lending attitude as perceived by firms has also been improving. Under these circumstances, the rate of decline in lending by private banks has been diminishing at a moderate pace. Moreover, the fund-raising environment for firms in the capital markets through CP and corporate bonds remains favorable. II. Conduct of monetary policy The Bank has been conducting the quantitative easing policy with the outstanding balance of current accounts held at the Bank as the operating target. The Bank has been providing ample liquidity to the money market in accordance with the current target range for the outstanding balance of “around 30 to 35 trillion yen,” which is far above the amount financial institutions are obliged to hold at the Bank by law or arrangements with the Bank. This has contributed to maintaining the accommodative environment for corporate finance through maintenance of the stability of financial markets. The Bank has made a commitment to maintain the quantitative easing policy until the year-on-year rate of change in the consumer price index (CPI; excluding fresh food, on a nationwide basis) registers zero percent or higher on a sustainable basis. This commitment has contributed to stabilizing market interest rates, and thus firms have been able to raise funds at low interest rates. The commitment’s positive effects through interest rates on the economy will strengthen as corporate profits increase with economic recovery. III. The Bank’s measures regarding the financial system after the full removal of the blanket guarantee of deposits As I mentioned earlier, the financial system in Japan has been regaining stability, and the blanket guarantee of deposits will be fully lifted on April 1, 2005. Financial institutions will be expected to amplify their efforts to develop innovative services tailored to customer needs, thus supporting economic activity. The Bank’s basic stance regarding financial system policy must shift its focus in response to this changing environment: from crisis management to supporting private-sector initiatives toward providing more efficient and advanced financial services via fair competition, while maintaining overall system stability. In order to contribute to enhancing the functioning and robustness of the financial system, the Bank will actively encourage financial institutions’ efforts to improve their business activities, and devise various ways to enhance its own business. Conclusion Although Japan’s economy is at a pause, it is expected to continue recovering with the further expansion of overseas economies and progress in adjustment in IT-related goods. To ensure that this recovery will become sustainable, the Bank considers it essential that a wide range of economic entities continue to make efforts to revitalize the economy. The Bank is determined to firmly support Japan’s economy from the financial side by maintaining monetary easing with the commitment based on the CPI, in the current situation where the CPI continues to fall slightly on a year-on-year basis. It has become increasingly important for the Bank to pursue more advanced services in a wide range of areas as well as ensure well-disciplined management to properly carry out the duties entrusted to it as the nation’s central bank. In light of this, the Bank has for the first time formulated a Medium-Term Strategic Framework (MTSF) for fiscal 2005-2009, which sets out the Bank’s management policy for the next five years. The Bank is committed to continuing its efforts, through the steady implementation of this MTSF, to retain public confidence and fulfill its mission of contributing to the sound development of the economy.
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Summary of a speech given by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the Keizai Doyukai (Japan Association of Corporate Executives) Members¿ Meeting, Tokyo, 13 May 2005.
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Toshihiko Fukui: Toward achieving strong economic growth in Japan Summary of a speech given by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the Keizai Doyukai (Japan Association of Corporate Executives) Members’ Meeting, Tokyo, 13 May 2005. * * * Introduction Semiannually in April and October, the Policy Board of the Bank of Japan decides the text of the Outlook for Economic Activity and Prices, or the Outlook Report as we call it, and releases it. This report describes the Bank's outlook for economic activity and prices which provides the basis for conducting monetary policy. We decided to extend the projection period for the April issues of the Outlook Report by one year to two fiscal years, and hence the report released at the end of April 2005 covers the outlook for fiscal 2005 and 2006. In deciding on the extension, the Bank gave consideration to the fact that it takes a certain amount of time for the effects of monetary policy to spread to economic activity and prices, and also looked at the practice of other central banks for reference. Today, I would like to explain first the current situation and the outlook for Japan's economic activity and prices, particularly the content of the April Outlook Report, focusing on the underlying mechanism of developments in economic activity and prices. I will then talk about the conduct of monetary policy in such an economic and price situation. I. The current situation and the outlook for Japan's economic activity and prices The Bank's projections for fiscal 2005 and 2006 presented in the April Outlook Report were, in summary, that the economy is expected to experience a relatively long period of growth, albeit at a moderate pace. The economy is currently experiencing the third recovery phase since the bursting of the bubble. In the past two recovery phases, the recovery soon ran out of steam, and the economy slipped back into recession. This time, however, the economy has been on a relatively long recovery trend, and this is likely to continue. Recently, Japan's economy has been experiencing a temporary pause, with the real GDP growth rate standing almost at the same level for three consecutive quarters from the second quarter of 2004. The major factor behind this is the progress in global adjustments of production and inventories of IT-related sectors. This has been evidenced by the sluggishness of exports of capital goods and parts, particularly those for semiconductor manufacturing equipment, and of IT-related goods such as electronic parts, and the continued decrease in production of IT-related goods. Given this situation, there was a view that the current economic recovery might stall. However, exports have started to pick up and production has stopped declining recently, and it is gradually becoming clear that the current pause is only a temporary one, leading to a sustainable growth path in the not so distant future, and not the prelude to a descent into an economic recession. Adjustments in IT-related sectors are likely to be completed around the middle of 2005 on the whole, although the degree of progress has differed by type of product: while adjustments for digital appliances have shown considerable progress, there has not been much in the case of mobile phones. Compared to the time of the bursting of the IT bubble in 2001, the current adjustments are likely to be mild and completed in a shorter period of time. Learning from the lessons of the IT bubble, firms have improved their global inventory management and were cautious about building up inventories. In addition, they started to make adjustments in inventories at a relatively earlier stage as soon as signs of weak demand emerged. All this contributed to alleviating the degree of adjustment. Furthermore, unlike the situation at the time of the IT bubble when demand concentrated on personal computers, there is a wider range of demand for IT products, such as digital appliances, in which Japan has a comparative advantage. This demand-side factor has also contributed greatly. Next, I would like to explain the background to the Bank's outlook that the economy is expected to experience a relatively long period of growth, albeit at a moderate pace, after adjustments in IT-related sectors are completed in the not so distant future and the economy emerges from the temporary pause. Our projection of continuing recovery is based on the fact that, in summary, both the economic and financial fundamentals have been strengthening. On the economic side, there has been progress in adjustments of firms' excessive production capacity, holdings of labor, and debts. Corporate profits have exceeded the level at the end of the bubble period and excess production capacity as perceived by firms has almost been eliminated, as was evidenced in the March Tankan (Short-Term Economic Survey of Enterprises in Japan). In addition, the diffusion index for employment conditions indicated that the number of firms that perceived they had insufficient holdings of labor exceeded those that perceived they had excessive holdings of labor for the first time since the 1992 survey on an all industries basis. On the financial side, measures have also been taken to restore the soundness of the financial system, particularly in terms of reducing nonperforming loans (NPLs), and these have made good progress. Against this background, blanket deposit insurance was fully lifted in April 2005 and the financial environment to support positive corporate activity is being established. Despite these improvements, the behavior of firms remains cautious on the whole. Although it may sound paradoxical, the economic recovery is projected to be sustainable but remain moderate against the background of such behavior. Business fixed investment continues to grow, and some firms have started to show a positive stance in their investment, however only to a limited extent. The majority of firms are still placing priority on using the high level of corporate profits to reduce interest-bearing liabilities and, in most cases where firms increase investment, the amount does not exceed cash flow. Given this cautious stance of Japanese firms, the tempo of the economic recovery is likely to remain moderate. At the same time, the moderate pace of recovery itself implies that Japan's economy is expected to experience a relatively long period of growth. While external shocks played a significant role in some past large fluctuations in the economy, there were cases where changes in domestic demand amplified cyclical fluctuation. When over-optimistic expectations about future growth emerge and an excessive level of business fixed investment and inventory investment is encouraged in the situation where the economy is becoming more active, it helps to boost the peak of the business cycle, but causes the trough to be deeper through additional adjustment stemming from the overshoot. Such large swings in the business cycle stemming from changes in domestic demand are not likely to occur in the current economic recovery, owing to the cautious behavior of firms. To translate this view into actual figures, the GDP growth rate is expected to be around 1.5 percent for both fiscal 2005 and 2006, slightly above the potential growth rate. As for the outlook for prices, the cautious behavior of firms, particularly firms' stance on restraining labor costs, will also play an important role. The rise in the prices of commodities at home and abroad, including crude oil, has pushed up materials costs, and therefore awareness of a risk of inflation on a global basis has begun to increase. However, the rise in materials costs has been significantly offset by increases in productivity in the corporate sector and by the restraint on labor costs. Particularly in Japan, the consumer price index (CPI) has not increased. Japanese firms are making more efforts to increase their productivity. Even though the percentage share of labor costs compared to the total added value created by the corporate sector has declined to the level recorded in the early 1990s, many firms seem to be maintaining their cautious stance of restraining labor costs. In addition, the effects of the decline in rice prices and the reduction in electricity and telephone charges are expected to continue for a while. The projected rate of change in the CPI on a year-on-year basis is around zero percent for fiscal 2005, and slightly positive for fiscal 2006, as these factors are having a strong effect on consumer prices, although gradual upward pressures basically continue reflecting the strength of the economy. II. Positive and negative deviations from the projected outlook As I have said before, our most likely projection is that Japan's economy will experience a relatively long period of growth, albeit at a moderate pace. Of course, in the two-year projection period, the possibility cannot be ruled out that shocks significantly affecting economic activity and prices might occur and cause upward or downward deviations from the projected outlook. The Outlook Report pointed out factors to which the Bank should pay due attention, as they could cause economic activity to deviate: developments in energy and materials prices, developments in the U.S. and Chinese economies, and developments in domestic private demand. I would like to comment on two points regarding the downside risks, namely, developments in energy and materials prices and developments in the world economy. With regard to the first point, nominal crude oil prices have been at historically high levels, although on a real basis they are substantially below their historical peak. This basically reflects the tight supply-demand situation due to a decline in spare production capacity in oil-producing countries with continuing expansion in the global economy. From a broader perspective, China and East European countries have joined the global market economy since the 1980s, and dramatically expanded their production capacity of various goods using their comparative advantage in labor costs. These changes have been putting downward pressure on the prices of final goods, and they have been causing the prices of raw materials to rise significantly by consuming substantial amounts of natural resources. It should be said, however, that some speculative movements have been observed in the recent rise in crude oil prices as evidenced in the fact that there were sharp price reactions to weather forecasts in the United States and Europe and reports on oil inventories in the United States. As evident in the fact that the crude oil consumption per unit of real GDP in Japan is only about 70 percent of that in the United States, Japan's energy efficiency is high compared to other economies, and this alleviates the negative effect of high crude oil prices on the economy. In addition, the yen's appreciation in the past two years has partially restrained the rise in crude oil prices denominated in yen. However, closer monitoring is required of the risk of downward deviation of the economy, due to possible emergence of a profit squeeze and decline in real purchasing power, as the price of Middle Eastern crude oil, which accounts for a significant proportion of Japan's imports, has risen in the current situation unlike during the price hike last year. In addition, as evident from continuing high price levels in the futures market, the possibility cannot be ruled out that expectations that crude oil prices will remain high may become more widespread. If the high price is actually sustained, the trajectory of global economic growth might deviate downward, and we need to be aware of the indirect effects of any deceleration of the global economy on the Japanese economy through the resulting reduction in exports. The second point I would like to discuss as downside risk is the outlook for the world economy. The world economy continues steady expansion, occurring mainly in the United States and China, and it is thought very likely that it will continue expanding at a rate roughly equivalent to the potential growth rate. At the meeting in April, the G-7 countries concurred that global expansion remained robust and economic growth in 2005 is likely to be solid. The IMF forecast of real GDP growth for 2005 and 2006 is 4 to 5 percent. Regarding price developments, the rise in energy and materials prices, including crude oil, has so far been absorbed by the corporate sector partly through productivity increases, and as a result, inflation has been contained. However, with the possibility of high materials prices continuing for a considerable period, awareness of a risk of inflation on a global basis has begun to increase. In the U.S. economy, although inflationary pressures are most likely to be contained, due consideration has been given to a possible increase in inflation expectations, since productivity growth has been decelerating and unit labor cost has been increasing in a situation where domestic supply-demand conditions are already tight. The U.S. Federal Reserve indicated its judgment on prices in the press release issued after the policy change in May as follows: "Pressures on inflation have picked up in recent months and pricing power is more evident. Longer-term inflation expectations remain well contained." The Bank will closely monitor, with consideration of their implications for the Japanese economy, changes in the global circumstances surrounding prices and the effects on the global economy through financial markets, for example, a rise in long-term interest rates. In China, strong economic growth is continuing supported by firm domestic and external demand. However, it is pointed out that fixed asset investment continues relatively high growth and there is the risk of an infrastructural bottleneck arising, for example from the shortage of electricity. China has structural problems, including the large income gap between metropolitan and rural areas. The Chinese economy should be watched carefully from the viewpoint of whether it can continue to achieve sustainable growth. III. Characteristics of corporate behavior and future prospects One of the characteristics of Japan's current economic recovery is that the economy is growing at a moderate pace. As I have already mentioned, this is against the background of cautious corporate behavior. In other words, if corporate behavior becomes more active, it could cause the outlook for economic activity and prices, which I have just explained, to deviate upward. One might wonder why firms continue to be cautious even in a situation of continued economic recovery with improved profitability. I will present some possible explanations for their cautious behavior. First, it is rational of firms to want to repay interest-bearing liabilities and increase capital as appropriate, because they have become more conscious of business risk and financial risk after experiencing the severe downturn in the business cycle after the bursting of the bubble and instability in the financial system. Firms have been strongly aware of the necessity of strengthening their resilience to unexpected shocks by squeezing inventories and fixed costs. They have also been making efforts to reduce their debt-to-capital ratios in light of the heightened awareness of credit ratings and financial markets' evaluation with the progress of globalization of financial markets. Second, the intensified global competition accompanying emerging economies' transition to market economy, which I mentioned earlier, is likely another factor. Cautious corporate behavior can be seen in most advanced nations, including the United States, though to a varying degree. The yield spread derived by subtracting the expected earnings on stocks from long-term interest rates has been on a declining trend in these countries. This means that the stock markets' expectations for economic growth have been declining. While corporate scandals in the United States related to accounting rules and delayed structural reforms in Europe may also have had some effect on investors' sentiment, intensified global competition seems to have contributed to the cautiousness of corporate behavior. It is quite natural for Japanese firms to feel that they are most exposed to global competition pressure partly due to Japan's geographical proximity to other Asian countries. In addition, there is increased awareness that there will be greater changes in the business environment in the future, such as further population aging as well as the lower birth rate resulting in a decrease in population. With the experience of a prolonged period of low economic growth, expected growth for the Japanese economy may have declined somewhat. According to a survey of firms conducted by the Cabinet Office, the expected growth rate over the next five years was declining from the level of 4 percent in the early 1990s. Although it has recently bottomed out and started to increase slightly, it is still at around 1 percent. Third and last, some point out that the present high profitability of firms has been supported by the extremely low interest rates and that this situation cannot continue forever. However, with advances in the process of structural adjustment, an environment is in fact being established for firms to take positive action. On the financial front, firms have been making progress in reducing debt. The ratio of corporate debt outstanding to sales for nonmanufacturers has declined, but is still slightly higher than in the first half of the 1980s. As for manufacturers, the ratio has declined to lower levels than in that period. In this situation, an uptrend in the capital ratio has become more marked for both manufacturing and nonmanufacturing firms. Firms have recently been active in equity financing, which has been a primary factor promoting these developments. In the extremely low long-term interest rate environment since 2000, the cost of corporate debt has declined significantly due to the progress in repayment and refinancing of past borrowings with high funding costs. Some say that the cost of corporate debt may have declined as far as it can. On the other hand, the profitability of large firms is above the levels during the bubble period and even that of small and medium-sized firms is at the highest level since the bursting of the bubble. As a result, profitability exceeds the cost of debt. This means that an environment is being established that encourages firms to use cash flow for business fixed investment rather than repaying debt. In view of the situation, an increasing number of firms are expected to use free cash flow for business fixed investment and other investments, and research and development, both for the purpose of growth, rather than for repaying their debt, with a view to enhancing corporate value in the medium to long term. Firms that have developed a strategy to diversify their business may make use of mergers and acquisitions. Due partly to strengthening corporate governance, firms may increasingly buy back their own stocks or increase their propensity to pay dividends, both of which would increase payouts to shareholders. An increasing number of firms will be taking a more positive attitude to business activity with funds they raise, taking advantage of an accommodative financial environment. On the employment front, an increasing number of firms may raise nominal wages and bonuses and recruit a larger number of new graduates in order to ensure that they have a sufficient number of skilled workers and to better attain a more balanced composition of workers. Such movements should spread in the process of the economy taking a balanced growth path, and this is in turn expected to enhance economic growth, creating cyclical momentum. So far, I have focused on corporate behavior in relation to overall economic activity. I intend to pay close attention to how these developments in the corporate sector affect prices. Looking at factors that push down prices, the price fall in Japan in 2001-02 was, to a large extent, due to the weakness in demand. Recently, however, downward pressure on prices stemming from weak demand has been abating, and that stemming from other factors is increasing. While the reduction in electricity and telephone charges against the background of deregulation is one of the factors, significant factors behind the fall in prices of final goods and services are higher productivity and, above all, firms' persistent stance of restraining labor costs. Two notable characteristics of the recent Japanese economy - that the economy is growing at a moderate pace and that consumer prices remain relatively unresponsive to the output gap - are both a reflection of firms' cautious behavior. Therefore, close attention should be paid to whether firms' activities become more positive and whether their stance of restraining labor costs might change. As expected economic growth increases, views on prices are expected to change. In fact, deflationary expectations of households and firms have been subsiding steadily since they peaked in 2001, as evident in recent surveys that show an increase in the percentage of individuals and firms expecting a rise in prices. The fact that land prices in the Tokyo metropolitan area are beginning to rise after the decline came to a halt may be a sign of an increase in expected economic growth. Attention should also be paid to how price expectations and land prices will develop in the future. IV. Monetary policy The Bank currently implements a quantitative easing policy with the outstanding balance of current accounts held at the Bank as the main operating target. The framework is based on the following two key elements. First, the Bank continues to provide ample liquidity to the money market. To be more specific, it has been providing ample liquidity so that the outstanding balance of current accounts at the Bank substantially exceeded the amount of required reserves, which is about 6 trillion yen at present. This will continue to generate confidence among market participants about raising funds and has resulted in an overnight call rate of almost zero. Second, the Bank has made a commitment, unprecedented in the history of central banks, to continue this policy until the year-on-year rate of change in the CPI (excluding fresh food, on a nationwide basis) registers zero percent or higher on a sustainable basis. This commitment will continue to have the effect of lowering longer-term interest rates by causing market participants to expect short-term interest rates to remain at zero for longer. V. The effects of monetary policy More than four years have passed since the Bank adopted the quantitative easing policy. While the framework of the policy has remained unchanged, the policy effects should continue to change over time depending on developments in economic activity and prices, and also the conditions of financial markets and the financial system. At around the time of the introduction of the quantitative easing policy, the real GDP growth rate was minus 1.1 percent year on year and the CPI decreased by 1.0 percent year on year for fiscal 2001. Furthermore, anxiety about financial system stability persisted as financial institutions were burdened with a large amount of NPLs. In this situation, there was a risk of a credit crunch as financial institutions became extremely cautious about extending credit to firms unless they were confident about raising enough liquidity, and there was strong awareness of the risk of the economy falling into a deflationary spiral. In such an economic and financial situation, the Bank needed to firmly maintain an accommodative financial environment by providing ample liquidity flexibly and in a timely manner, thereby easing the public's and market participants' concerns about the availability of funds and ensuring stability in the financial markets. As a result of the Bank's provision of ample liquidity, financial markets remained stable and rapid tightening in corporate financing was not observed, even when financial institutions' liquidity demand had continued to rise in a situation where, for example, bank stocks plunged and there was heightened uncertainty regarding measures to deal with the NPL problem in the fall of 2002. During this period, in a sense, the policy effects stemming from the ample liquidity provided by the Bank, through which concern about the availability of liquidity was eased, may have been greater than those of the Bank's policy commitment, namely, its commitment in terms of policy duration. Since then, both the economy and the financial situation have been on an improving trend. Since fiscal 2002, the year-on-year growth rate of real GDP has been positive, and the year-on-year rate of decline in consumer prices has diminished to almost zero percent. An accommodative corporate financing environment has been supporting these developments. Together with an increase in financial institutions' capital adequacy ratios and an improvement in firms' financial strength and profitability, increased confidence among financial institutions and firms about the availability of funds brought about by the quantitative easing policy has produced this desirable environment. The quantitative easing policy framework provides stronger support for economic recovery, the more the economic recovery gains momentum. Here, the effects stemming from the Bank's commitment in terms of policy duration are gradually playing a larger role than those stemming from ample liquidity provision by the Bank. Interest rates usually rise with an improvement in economic activity and an increase in prices. The Bank's commitment, however, keeps longer-term interest rates low by stabilizing expectations about the future level of interest rates, and this will allow firms to continue to enjoy low funding costs. While funding costs remain low, the rate of return on investment increases with economic recovery, and, accordingly net returns on investments in economic activity will improve. The quantitative easing policy has continued to contribute to the Japanese economy with some changes in the way it affects the economy, as I have just described. Recently, the market situation that surrounds the policy is changing significantly with the enhanced soundness of the financial system and abatement of anxiety about financial system stability. Financial institutions have become more confident about raising funds in the market. Furthermore, they are increasingly placing emphasis on strengthening their profitability with a view to improving their credit ratings and raising stock prices, and this may have been reducing their incentive to maintain funds in current accounts at the Bank that yield no interest. As financial institutions' demand for liquidity has been declining, their demand for funds supplied through the Bank's market operations has decreased. Recently, as a result, undersubscription, where financial institutions' bids fall short of the Bank's offers, has occurred frequently in funds-supplying operations. This phenomenon can be considered as an encouraging sign that the conditions surrounding the financial system have improved. This situation, in turn, is causing difficulty in providing funds through the Bank's market operations. At Monetary Policy Meetings, Policy Board members have been discussing whether to maintain the current high target range for the outstanding balance of current accounts at the Bank. I must stress that the discussions have been from the viewpoint of examining what is the most appropriate way for the Bank to maintain the current quantitative easing policy framework, in response to the current situation where financial institutions' demand for liquidity is declining and financial market conditions are changing. The Bank will firmly maintain the framework whereby the Bank provides ample liquidity significantly exceeding the required reserves in accordance with its commitment based on the CPI, thereby firmly maintaining monetary easing. I would like to explain our thinking in relation to the timing of the change in the policy framework. As I explained earlier, the forecasts of Policy Board members for the year-on-year rate of change in the CPI are around zero percent for fiscal 2005 and slightly positive for fiscal 2006. Price developments may deviate from the forecasts due to deviations of economic activity from the projected path, and also to factors unique to prices, for example, emergence of inflationary sentiment or the effects of various measures to promote competition such as deregulation. Therefore, it is not certain whether the conditions in the Bank's commitment will be fulfilled and there will be occasion to change the present framework of the quantitative easing policy during the projection period covered in the April Outlook Report. However, assuming that our projections regarding prices in fact materialize, it is likely that this possibility will gradually increase over the course of fiscal 2006. Nevertheless, if economic activity and prices continue to be in line with our projections presented in the Outlook Report, that is, higher productivity and other factors continue to contain to a large extent upward pressure on prices as the economy follows a sustainable and balanced growth path, this will likely give the Bank latitude in changing the policy framework and in conducting monetary policy thereafter. I hope that the management of Japanese firms, including those of you present at this meeting, will take advantage of the current accommodative financial environment and take up new business opportunities in a more positive manner. I am confident that this will lead to more dynamic development of the Japanese economy.
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Opening speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the 12th International Conference hosted by the Institute for Monetary and Economic Studies, Bank of Japan, 30 May 2005.
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Toshihiko Fukui: Incentive mechanisms for economic policy makers Opening speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the 12th International Conference hosted by the Institute for Monetary and Economic Studies, Bank of Japan, 30 May 2005. * * * Introduction Good morning, ladies and gentlemen. I am very pleased to address the 12th international conference hosted by the Institute for Monetary and Economic Studies. On behalf of my colleagues at the Bank of Japan, I welcome participants from all over the world. Over the last twenty-four years, we were fortunate to have the best minds from the academia and central banks come together at previous Conferences to discuss current issues in central banking. I would like to thank everyone who has been involved, because the positive reviews we received are reflections of all the commitments in time and efforts of the people attending the Conferences. From this year, the Institute will hold the Conference every year, not every other year. This should enable us to cover a wider range of monetary and economic issues in a more timely manner. The new annual Conference format should offer more opportunities for candid exchanges of views between central bankers and scholars. I hope that you would extend to us your continued support for our future Conferences. Theme of this year's conference This year, we discuss how to design incentive mechanisms for economic policy makers. Institutions and the incentive mechanisms they engender collectively influence economic performance. Some institutions create incentives to induce efficient behavior, and others do not. Take two of the broadest of institutions, a market economy and a centrally planned economy. In a market economy, the market price signals any excess demand or supply, and creates incentives for producers. When the market price is higher than the equilibrium price, a producer has an incentive to increase his or her production and increase sales. On the other hand, a producer also has an incentive to cut back on his or her production when the market price is lower than the equilibrium price. Meanwhile, increased supply will let the market price fall and vice versa, until the market is cleared at the equilibrium price. Such an incentive mechanism achieves efficient resource allocation in a market economy. In a centrally planned economy, the track record of central planning agencies is dismal. They generally failed to structure incentives for a producer to autonomously respond to excess demand and excess supply. At the same time, central planning agencies themselves lacked proper incentives to identify changes in demand, and consequently, often failed to instruct producers to produce according to changes in demand. Efficient resource allocation was not achieved. It is no wonder then that centrally planned economies collapsed around the world by the 1990's. Institutions and their incentive mechanisms play a key role in determining economic performance. Failure of incentive mechanisms in a market economy The market price is not the only source of incentives in a market economy. Some incentive mechanisms, however, fail to induce efficient behavior. For example, incentives influenced the course taken by Japanese banks in dealing with the problem of non-performing loans. Until the late 1990's, the Japanese regulatory and institutional environment did not motivate banks to take prompt actions that would have prevented their balance sheets from deteriorating further. For example, the latitude banks had in the disclosure of non-performing assets enabled banks to withhold information, perfectly legally, on the full extent of their problems. As a result, market discipline could only play a limited role. At the same time, measures available to regulators and supervisors were rather limited. A bigger stick would surely have helped the authorities to persuade banks to take more decisive actions. Finally, in the late 1990's and early 2000's, various policy measures were introduced to better align the incentives of banks. They included the introduction of more precise standards for disclosure and prompt corrective actions by the FSA. The functions of the Deposit Insurance Corporation were strengthened as well. The Bank of Japan encouraged Japanese banks to make an appropriate evaluation of their loans by using discounted cash flow method. These measures finally generated proper incentives for Japanese banks to put their houses in order. The recent removal of the blanket guarantee of deposits was a symbolic event in this regard. This example suggests that incentive mechanisms could affect the stability of the financial system. The central bank has a vested interest in the design of such incentive mechanisms. Incentive mechanisms for a central bank Central banks are not free from incentives created by their institutional settings. For example, in the past, governments in the industrialized economies tended to regard that there was a trade-off between high growth and moderate inflation. This created an environment where central banks would acquiesce inflation resulting from above-potential economic growth. The stagflation in the 1970's could be regarded as a consequence of such misguided institutional incentives. Fortunately, we have learned from history. From the late 1980's onwards, there seems to be a growing recognition among governments in the industrialized economies that central banks should aim for price stability, which is a precondition for governments to achieve sustainable growth. Accordingly, many central banks today are conducting monetary policy under a more favorable mix of incentives. The key ingredients are independence from the government and accountability in decision making. The specific mandate for price stability varies from a central bank to a central bank. Some central banks are required to hit specific numerical targets, and others do not. An example of a rather specific target is the policy target agreement 2002 between the Minister of Finance and the Governor of the Reserve Bank of New Zealand. The agreement says that "the policy target shall be to keep future CPI inflation outcomes between 1 per cent and 3 per cent on average over the medium term." Another example, which is less specific, can be found in Article 2 of the Bank of Japan Law. It says: "Currency and monetary control shall be aimed at, through the pursuit of price stability, contributing to the sound development of the national economy." From my point of view, and I believe my central bank colleagues would agree, the most important outcome is not hitting a specific numerical target. The achievement of price stability today in terms of a particular price index does not always guarantee sustainable growth in the future. It is, therefore, important to design and put in place an institutional setting that would create incentives for a central bank to pursue a price path consistent with sustainable growth. Incentive mechanisms for a monetary policy committee Incentives matter to central banks, not only at the level of macroeconomic targets, but also at the micro-level of day-to-day decision making. In other words, if the people decide that delegating price stability to the central bank leads to the achievement of price stability, how should the central bank make its decisions? In the growing number of cases, including the Bank of Japan, committees formulate monetary policy. Though there is an old saying that a camel is a horse designed by a committee, I feel that there are advantages in monetary policy by committees. At a minimum, it enables a thorough discussion of issues reflecting the diverse background of committee members. On the other hand, the very fact that a monetary policy committee consists of different people with different opinions could create conflicting incentives within the committee. The chair of the monetary policy committee that consists of different people with different opinions must, therefore, take care in aligning the incentives of members and hopefully arrive at a consensus. I remember, in a recent publication, Professor Alan Blinder describing Chairman Greenspan as leading the FOMC "with a velvet glove, not with an iron fist." This shows the delicate task of the chair in dealing with diverse if not diverging incentives. As to myself, I keep a few points in mind as chair of the Board of the Bank of Japan. First, I welcome counter arguments or minority opinions, which contribute to a better decision in the end. Secondly, I refrain from actions that might result in undue influences over the discussions. If I might give you a glimpse of the inner workings of the Board, instead of making an opening statement, I always ask other members to identify issues and express their opinions. Final words Designing institutions and policies that incorporate appropriate incentive mechanisms plays a crucial role in determining the economic performance of an economy. Policy makers, including the central bank governor, still have a lot to learn in this respect. Through the next two days, I am looking forward to hearing from experts in this field, from both academic circles and central banks, their analyses and views on the designs of various incentive mechanisms in various institutions. It would be our utmost pleasure if every one of you could take home some insights from these discussions. Thank you very much.
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Remarks by Mr Toshihiko Fukui, Governor of the Bank of Japan, at The Bank of Korea International Conference 2005, Seoul, 27 May 2005.
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Toshihiko Fukui: On stabilisation policies - a central banker’s reflection Remarks by Mr Toshihiko Fukui, Governor of the Bank of Japan, at The Bank of Korea International Conference 2005, Seoul, 27 May 2005. * 1. * * Introduction Good morning, ladies and gentlemen. It is my privilege to speak at the beginning of the Bank of Korea's international conference. At the outset, please allow me to strike a personal note. I meet with BOK Governor Park rather frequently, maybe four or five times a year. At the end of each of our conversations, I am impatient for our next meeting. Therefore, it is a tremendous pleasure to see him again this morning, although it is only a month since we had lunch together on a southern Japanese island. Like our personal relationship, official ties between our two central banks are also close. To avoid using up the time accorded to me, I just point out the fact that, for the first time in many years, the Bank of Japan posted one official at the Japanese embassy in Seoul to cultivate better communication with the Bank of Korea and other contacts here. Today's symposium covers a broad range of aspects of macro-economic stabilization policies - that is, monetary and fiscal policies. While the phrase "stabilization policies" has been popular for nearly half a century, we can interpret this in a variety of ways. Believing that the profundity of this topic will be revealed in the sessions today, I would rather like to present my personal reflections on Japan's economic policy management over the past two decades when we struggled to stabilize our economy. 2. Japan's success and failure Let me begin with a brief sketch of what Japan's economy went through after World War II. We began the post-war reconstruction by creating a uniquely Japanese system. It was built on a tight nexus of the social, political and economic apparatus, with top priority given to attaining high economic growth. Among the striking features of this system were political stability, strong bureaucracy, and lifetime employment. The so-called "iron triangle" between politicians, bureaucrats, and business people was very powerful in promoting growth-oriented business models and building an export-led industrial structure. As it turned out, this was a marvelous success. Unfortunately, success creates inertia - an intrinsic resistance to change, even when the old system begins to falter. From the early 1980s, globalization and technological innovation began transforming the world economy, posing new challenges for Japan's economy. External imbalances and trade friction led to the currency re-alignment of the Plaza Accord in 1985. This put deflationary pressures on Japan's economy, while making traditional segments of our economy obsolete. In order to fend off the deflationary forces, Japan made full use of macro-economic policies. The government stepped up fiscal spending to boost domestic demand. The Bank of Japan (BOJ) eased monetary policy for an extended period of time, consequently fuelling the rapid boom in the economy. Together with various structural factors, these expansionary policies spawned distortions in Japan's economy. To name just a few examples, we saw a nation-wide surge in resort area development at the expense of our green environment. We embarked on the re-development of metropolitan Tokyo to make it an international financial hub, but with little coherent strategy in hindsight. Fiscal profligacy by the government, which I referred to just a few seconds ago, resulted in the building of local roads and ports barely used by travelers - a classical faux pas of pork-barrel politics. Such economic frenzy generated irrational growth expectations, further prompting excessive investment in both real and financial assets. As you know, the upshot of this euphoria was the asset bubbles and their subsequent bursting. All these episodes point to one thing: despite the substantial changes in its external circumstances, Japan was not able to depart from the development model it cherished during the economic catch-up period. We had many discussions about how to reform our system in the face of the headwind against Japan's economy after the Plaza Accord, but we did not follow our words with action. Put differently, it was a reform by word, not in deed. After the collapse of the economic bubbles in the early 1990s, we finally learned that every boom must evaporate some time. An aging population and declining birth rate also forced us to acknowledge the need to revamp our modus operandi so that we could remain viable in global competition. This perception shift marked the beginning of the long adjustment phase from the mid-1990s - a harrowing decade when Japan's private and public sectors tried to reinvent themselves. The corporate sector tried hard to get rid of the negative legacies of the bubble era - that is, excesses in production capacity, labor, and debt. Although hard hit by falling employment and wages, the household sector endured relatively well during this painful adjustment. As the old financial system suffered setbacks amid the bubble burst, Japanese financial institutions faced a mountain of non-performing assets. In the process of cleaning them up, banks not only exhausted the wealth they had accumulated during the high-growth years, but also had to rely upon government bailouts. In the 1990s, the Japanese government provided large fiscal stimuli to prevent economic stagnation from worsening. But it also pursued deregulation, as a supply-side measure, to foster business formation and innovation. What did the Bank of Japan do in this adjustment process? We began to ease monetary policy in July 1991, when the consumer price index still registered an increase of around 3%. In September 1995, the official discount rate dropped to 0.5%, the lowest ever recorded in the history of central banks in the world. In February 1999, the BOJ adopted the zero interest rate policy, followed eventually by the quantitative easing policy - again unprecedented in central bank history - that has been in place since March 2001. Monetary easing in this unprecedented fashion cushioned depressive ramifications from the structural adjustment in the corporate and personal sectors. Also, the ample provision of funds by the BOJ was effective in reducing liquidity squeeze in financial markets at a time when systemic instability and credit crunch were the real threats to the Japanese financial system. After 13 years of policy struggles, progress has begun to materialize in unwinding past excesses. Major Japanese banks are now in much better shape. Corporations are posting brighter earnings outcomes than ever, and household incomes have begun to improve. Against this backdrop, we removed the blanket deposit insurance on April 1st, 2005. Considering that the blanket guarantee was maintained as a financial emergency measure, Japan's economy has passed a critical milestone. The next milestone will be passed when Japan brings its economy back on a sustainable growth path. From the medium-term perspective, Japan needs to carry out the structural overhaul of its public sector, too. For instance, the legacy of an activist fiscal policy throughout the 1990s is still with us, as shown by the huge public debt nearing 160% of our GDP. This leads us to conclude that fiscal consolidation should be examined in a well thought-out manner. Re-designing our social security system in the context of demographic adversity is another policy imperative. No doubt, these are large challenges. 3. Policy lessons from Japan's experience At this juncture when Japan's structural adjustment has come quite a distance, it might be informative to take stock of some monetary policy implications from our decade-long struggle. First, in connection with the leitmotif of today's conference, we should not restrict central banks' stabilization policy to a narrow domain of macroeconomic management. There could be circumstances where a central bank needs to play a critical role in safeguarding the stability of the financial system. In addition, the effectiveness of monetary policy hinges crucially on the proper functioning of financial markets and the financial system. This is because monetary policy is implemented through central banks' lending, deposit-taking, money-market operations, and other activities in financial markets. If financial stability is at risk, central banks' policy would be severely constrained. Throughout the 1990s, the BOJ conducted its policy while paying close attention to the condition of the financial markets and the financial system. This was especially true in the late 1990s when the systemic dysfunction of our banking system was apparent. Second, central banks need to tackle two elusive but inter-related questions: how do asset price fluctuations affect economic stability; and how should a central bank respond to big swings in asset prices? A de-coupling of asset prices and general prices is not necessarily rare. Besides Japan's anomalous experience in the bubble period, recent examples of this sort have been seen in the United States, Britain, and Australia. In many advanced economies, asset prices tend to rise in sync with a cyclical economic upturn, while general price indices are becoming less responsive due to productivity growth and firms' cost retrenchment amid global competition. However, Japan's painful experience tells us that central banks should keep a close watch on asset prices, for they could have a material impact on the economy and inflation in the medium to long run. Central banks should also be alert to the excessive growth in money and credit which often accompanies asset bubbles. I presume such vigilance should somehow be blended into our conventional wisdom that central banks contribute to economic stabilization by ensuring price stability. 4. Concluding remarks Now, let me conclude. As I said earlier, the most pressing task for the Bank of Japan at this moment is to achieve sustainable growth on the basis of price stability. Towards that goal, the BOJ is firmly committed to maintaining the current easing policy. I am impressed at how Korea has pushed forward structural reform in a wide range of areas following the economic crisis in 1997. I am sure the Bank of Korea has made a significant contribution to this economic revival, and will continue to build more on its success. I would like to express my respect for the decisive leadership of Governor Park. This conference brings together many eminent scholars and central bankers. I am sure that, based on analysis of the bitter experiences of both Japan and Korea, the confluence of their expertise and insights will provide a thought-provoking discussion of this complex issue of stabilization policies. Thank you for your attention.
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Summary of a speech given by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, at a meeting with business leaders, Oita, 23 June 2005.
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Toshiro Muto: The outlook for Japan’s economy Summary of a speech given by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, at a meeting with business leaders, Oita, 23 June 2005. * * * I. Japan's economy: current situation and immediate prospects Japan's economy has been at a temporary pause since summer 2004 due partly to adjustments in production and inventories of IT-related goods. Inventory adjustments in IT-related sectors are still continuing, but steady progress has been made and production is increasing moderately. Corporate profits have been at high levels, and this has not only led to an increase in business fixed investment but also had positive effects on the household sector through a rise in household income. The result is that private consumption has been steady, as evidenced by the fact that various sales indicators increased in the January-March quarter and have continued to be relatively strong. Therefore, the underlying mechanism of economic recovery remains firm, although recently growth in exports has been sluggish, especially in those to China. In the not so distant future, the economy is likely to gradually emerge from the current plateau and move onto a sustainable growth path. The Bank of Japan's economic outlook is explained in detail in the Outlook for Economic Activity and Prices (the Outlook Report) released at the end of April 2005. In short, the economy is expected to experience a relatively long period of growth, albeit at a moderate pace. In terms of real GDP growth, the growth rate is expected to be around 1.5 percent for both fiscal 2005 and 2006, slightly above the potential growth rate. On the price front, the consumer price index (CPI) has been declining slightly on a year-on-year basis partly due to the decline in rice prices and the reduction in electricity and telephone charges caused by the intense competition accompanying deregulation. The effects of the rise in domestic and overseas commodity prices, including the surge in crude oil prices, has been largely contained due to a decline in unit labor costs (labor costs per unit of output): in other words, wage growth has been restrained compared to the rise in productivity. Even though labor's share of the total value added generated by the corporate sector has declined to the level recorded in the early 1990s, many firms are still cautiously continuing to restrain labor costs. In addition, the effects of the decline in rice prices and the reduction in electricity and telephone charges are expected to continue for a while. Although underlying economic strength continues to exert gradual upward pressures, a marked increase in prices is unlikely in the immediate future. In the April Outlook Report, consumer prices are projected to remain around zero percent on a year-on-year basis in fiscal 2005, and to become slightly positive in fiscal 2006. The Bank's outlook for economic activity and prices is based on the perception that firms' business stance will remain cautious. The recent recovery phase is characterized by its moderate pace and the scarcity of signs of acceleration. Furthermore, the spread of the recovery to regional economies remains weak. As evidenced by the continued increase in business fixed investment observed at the macroeconomic level, some firms are taking a more positive stance. Such cases are, however, still limited, and a large number of firms with increased profits are still placing priority on reducing interestbearing liabilities and taking a "wait-and-see" attitude toward investment. Most firms have kept any increases in business fixed investment within the limits of their cash flow. Given that Japanese firms maintain this cautious stance, the pace of economic recovery is likely to remain moderate. At the same time, the fact that the pace of recovery is moderate increases the chances of a relatively long period of growth. Looking at past economic fluctuations, corporate activity is seen to have amplified cyclical fluctuations in some instances. As economic activity picks up, the emergence of over-optimistic expectations about future growth tends to trigger an excessive level of business fixed investment and inventory investment. Such a situation may heighten the peak of the business cycle, but it also deepens the trough thereafter as additional adjustment is needed to compensate for the overshooting. However, these kinds of large swings in the business cycle are unlikely to occur in the current economic recovery, owing to the cautious behavior of firms. In the long term, the cautious business stance of firms will hinder the economy from realizing and building on its potential strength. Amid increasing competition and a rapidly changing technological environment, the maintenance of high profitability in the medium term requires that firms continue to 1/6 invest in highly profitable areas while ensuring that management resources are promptly reallocated in response to constantly changing circumstances. If firms remain cautious and postpone new investment, realizing the economy's potential, let alone enhancing that potential, becomes more difficult. With this in mind, I would now like to reexamine the nature of the structural adjustment pressures faced by the economy in the 1990s. These, I believe, will help shed some light on why there has not been more widespread positive activity in the corporate sector and what measures should be taken to encourage its spread. II. Two types of structural adjustment pressure faced by the Japanese economy The first type of structural adjustment pressure faced by the Japanese economy in the 1990s was the pressure to change the industrial structure exerted by the expansion of supply capacity in Asian countries. Other Asian countries have more abundant supplies of labor than Japan, while Japan has a comparative advantage in terms of capital stock and technology. Economic theory suggests that the Japanese manufacturing sector will focus less on labor-intensive manufacturing industries whose products can be substituted with imports from other Asian countries and tend to specialize in capitalor technology-intensive industries. Theory also suggests that, if growth in the nonmanufacturing sector can be realized, this will enable the surplus labor emerging as the share of labor-intensive industries declines to be successfully absorbed. The expansion of production capacity in Asian economies was therefore expected, through the adjustment process detailed above, to shift the Japanese economy's orientation from external demand to domestic demand. In the event, the manufacturing sector witnessed both increased specialization in capital- or technology-intensive industries and a decline in the share of labor-intensive industries. However, Japanese firms' efforts to reallocate their business resources, concentrating on highly profitable markets and withdrawing from other areas, ended up being only moderately successful. They could not keep up with changes in business conditions that were remarkable for their extent and the speed with which they occurred. The profitability of individual firms thus dropped significantly. In addition, the poor performance of the manufacturing sector hindered growth in the nonmanufacturing sector: household income declined, and generation of corporate demand such as advertising activities and computer software development was weak. As Japanese consumers became more sensitive about prices, especially the balance between price and quality, there was an unprecedented level of import penetration from other Asian economies, and this was part of the reason why the nonmanufacturing sector, particularly the wholesale and retail industry, also ended up suffering from a significant drop in profits. In addition to adjustment pressure affecting the Japanese industrial structure, another type of adjustment pressure is associated with the fall in land prices after the bursting of the economic bubble. This had a powerful negative impact, on the nonmanufacturing sector in particular. It is a well-known fact that the significant fall in land prices gave rise to a huge amount of nonperforming assets in the real estate, and wholesale and retail industries. This has impacted negatively on the entire economy by generating nonperforming-loan problems at financial institutions and reducing their risk-taking capacity, as well as by damaging the balance-sheet soundness of firms holding nonperforming assets. In the 1990s, the Japanese economy was therefore unfortunate enough to be simultaneously confronted with two types of structural adjustment pressure different in nature: the pressure to change the industrial structure and the pressure related to the decline in land prices which caused balancesheet problems. As a result, the surplus labor in the manufacturing sector generated as production of labor-intensive goods contracted was not absorbed by growth in the nonmanufacturing sector. Instead, the phenomenon of surplus labor was observed in almost all categories of both manufacturing and nonmanufacturing industry. This was markedly different from that witnessed in the U.S. economy in the early 1990s, when the decline in the number of employees in the manufacturing sector was perfectly offset by increased employment in the nonmanufacturing sector, especially in the health-care and information services industries. The 1990s has thus become known to Japanese economic history as the "lost decade." III. Progress in dealing with these structural adjustment pressures Since the mid-1990s, most Japanese firms have devoted considerable efforts to downsizing and restructuring their businesses. The actual implementation of business restructuring has differed significantly across individual firms, depending on specific conditions at firms and within their given 2/6 industries. It has ranged from drastic cost-cutting efforts, gradual withdrawal from business areas offering only low profitability while expanding operations in strategically important areas, and the thorough disposal of nonperforming assets, to forging alliances with rival companies when individual restructuring efforts proved unsuccessful. In the event, these efforts seem to be bearing fruit, and clear progress in dealing with the two types of structural adjustment pressure can recently be observed in the indicators even at the macroeconomic level. Worth specific mention are the progress in dealing with the three excesses, namely excess capacity, labor, and debt; and the bottoming out of land prices. In the Bank's March Tankan (Short-Term Economic Survey of Enterprises in Japan), for example, the relevant production capacity indicator showed a significant contraction in the extent of excess capacity. Moreover, the most recent diffusion index measuring tightness in the labor market registered a labor shortage for the first time since November 1992, although its extent was marginal. There is also an increasing number of firms intending to hire regular employees. The debt-to-sales ratio peaked in 1993, declining thereafter and currently down to a level last seen in the mid-1980s. Japanese firms have continued efforts to repay their debt, and as a result, about one-third of listed firms currently run their business with almost no debt. As for land prices, these have bottomed out and begun to rise, especially at the top end of the market. Looking at price movements for individual locations, the prices of locations near the top end of the market, which are considered to have high utility value, are seen to have either stopped declining or to have started to increase. According to the latest Urban Land Price Index, which surveyed land prices as of end-March 2005, although prices for all districts continue to decline, the pace of decline in the six major metropolitan areas has clearly slowed down. Within these six areas, prices of land in commercial districts have started to increase for the first time in 14 and a half years. Firms' efforts to improve their capability of generating high-value-added products and services have combined with the above developments to contribute to drastic profitability gains at Japanese firms. For example, the ratio of current profits to sales has almost reached its bubble period level. Presuming that progress in dealing with their problems is ultimately reflected in firms' profitability, the current situation may be considered evidence of light at the end of a long tunnel for Japanese firms. IV. Remaining issues and proposed solution strategies In spite of this progress in addressing their problems, positive forward-looking business activity has not been widespread among firms. Various factors lie behind this, but the main one is the substantial fall in people's expectations of economic growth which has been generated by the prolonged period of sluggish economic growth. In fact, the Annual Survey of Corporate Behavior released by the Cabinet Office showed that firms' expectations with regard to Japan's economic growth tend to be based on movements in actual growth over the preceding few years. Applying this to future economic developments, the effects of the prolonged period of sluggish economic growth may be expected gradually to fade and firms' expectations of growth to increase once the economy returns to a sustainable growth path. However, even when memories of past experience gradually fade away, firms' expectations of growth will not increase if they do not respond proactively to recent changes in the economic environment. Among these changes, those considered most crucial by corporate management are the issues of the ageing population and the declining birthrate. I will elaborate on these in what follows. As far as the economic effects of these demographic trends are concerned, the workforce has been declining since 1999, and this will eventually depress economic growth, unless labor is substituted with capital assets or there is an increase in the rate of technological innovation. The personal saving rate of the elderly is relatively low, so that a rise in the proportion of the elderly in the population will result in a fall in the overall saving rate. Should such a decline in saving reduce capital accumulation, this might also act to depress economic growth. In fact, the speed at which the population is ageing and the birthrate declining has recently been accelerating rapidly. This trend has not only exacerbated concerns about a possible contraction of the domestic market, but also added to the numbers worried that the pension, medical care insurance, and various other social security systems might be forced toward bankruptcy. Thus, most of the problems confronting the Japanese economy can be linked either more or less directly to the issues of population ageing and the declining birthrate. In light of this, we must give top priority to finding a way to stop the trend, especially the decline in the birthrate. Entangled with this issue, however, are people's individual values and notions of how the social structure ought to be, so that identifying some quick-acting remedy is difficult. The proposed 3/6 policy must therefore be efficacious, but it must also be steady and long term in scope. We must overhaul the labor market so as to encourage greater labor force participation, while simultaneously realizing a social environment in which people feel the desire to start families and raise children without needing to worry unduly. The government has an important role to play in this regard, and in fact, with the establishment of a new committee in the autumn of 2004 to consider social remedies for the declining birthrate, there has been a concerted effort by all government ministries and agencies to determine appropriate measures for areas of top priority such as enhancement of child care services. Turning to the ageing population, however, the position is somewhat different. It should be noted that this phenomenon is a result of Japan's economy and society having successfully developed, meaning that people can live longer and healthier lives than in previous generations. The ageing of the population should therefore be seen as a positive development even for firms. Looking at firms' actual behavior, although concern about major changes in the economic environment is deep-seated, many firms are actively engaging with the ageing population, treating it as a new business opportunity. For example, there are many cases where firms have targeted their marketing strategies at the elderly, and have succeeded in stimulating consumers' drive to spend, particularly among those with high levels of disposable financial assets. This success is seen in consumption of various goods and services, such as expensive digital appliances, particularly flat-panel TVs; expensive package tours both within Japan and overseas; educational services promoting lifelong education and self-improvement; and services related to well-being and sports. Given that the ageing of the population may thus be seen to provide a wide range of business opportunities for firms, there still appear to be plenty of growth opportunities for nonmanufacturers and in sectors catering to domestic demand, even with a falling population. Business opportunities are not restricted to the domestic arena, and Japanese firms will of course always retain the option of extending their operations overseas. Recently, Japanese firms, not only manufacturers but also nonmanufacturers such as retailers, distributors, trading houses, and financial institutions, have been actively engaged in business in Asia. This business includes not only relocating labor-intensive production but also increasing project variety by promoting technology transfer, opening up new markets, and enhancing local sales, all of which further the expansion of Japanese firms' overseas business. Those of you who live in Oita and other parts of Kyushu can experience the impact of globalization more directly due to your geographical proximity to other Asian countries. Dealing with changes in the economic environment requires a head-on and proactive approach from Japanese firms rather than a "wait-and-see" attitude. The most effective prescription for survival is for firms to sharpen both their ability to respond incisively to changes and the creativity with which they provide attractive new products and services. From the viewpoint of the overall Japanese economy, unless Japanese firms succeed in developing business aggressively in global markets and expanding domestic income, then it becomes rather hard to envisage growth in domestic demand. The need for firms to respond proactively to changes in the environment does not apply only to demographic changes such as societal ageing and the declining birthrate, but is of more fundamental relevance. During past phases of high economic growth, economic recovery spread throughout the country via increases in public investment. However, this conventional mechanism of economic recovery is changing, and firms are seeking ways to revitalize regional economies by taking advantage of their regional uniqueness to provide high-value-added products and services. The more proactively firms tackle changes in the environment and take advantage of the resulting business opportunities, the more solid the footing of the economic recovery. As such activity spreads and the recovery becomes clearer, expectations of growth will gradually rise. It is even possible to envisage the emergence of a virtuous cyclical mechanism in which rising expectations of growth fuel further progressive activity by firms. V. Structural adjustments and macroeconomic policies For firms to become more proactive in tackling changes in their environment, implementation of structural reforms aimed at raising the productivity of the overall economy is a prerequisite. The Bank has repeatedly emphasized this point. Specifically, there should be a thorough review of fiscal expenditure which should be better geared toward stimulating private demand and raising the productivity of the overall economy. At the same time, easing the regulatory burden on firms and making it easier for them to undertake new business is also vital. Moreover, alleviating public concern about pension and medical care insurance and other social security systems is a sine qua non for households to be able to spend money freely. Once the implementation of these structural policies 4/6 leads people to expect the productivity of the overall economy to increase, there will be a positive impact on firms' investment activity and household spending behavior. Within the context of structural adjustments as a whole, what then is the role of the Bank's monetary policy? In this regard, the Bank is often criticized for maintaining monetary easing, on the grounds that this may hinder necessary adjustments by allowing unprofitable firms to stay in business. As described earlier, the two types of structural adjustment pressure, the pressure acting to change the industrial structure and the pressure associated with the fall in land prices, are subsiding. In this situation, the prospect of a sustainable economic recovery has gradually become more realistic. Firms, however, have not yet become sufficiently vigorous in pursuing new business opportunities, leaving room for concern about their response to remaining issues. With this in mind, the role expected of macroeconomic policy, including the Bank's monetary policy, is to ensure a favorable economic environment that enables necessary adjustments to be carried out smoothly, while being careful not to distort resource allocation too much. VI. The Bank's conduct of monetary policy Based on this thinking, the Bank has continued to implement the quantitative easing policy with the outstanding balance of current accounts held at the Bank as the main operating target. The framework is based on the following two key elements. First, the Bank continues to provide ample liquidity to the money market. To be more specific, it has been providing such ample liquidity that the outstanding balance of current accounts at the Bank has substantially exceeded the amount of required reserves, which is about 6 trillion yen at present. This has continued to generate confidence among market participants about raising funds and has resulted in short-term interest rates of almost zero percent. Making financial institutions feel secure about the availability of funds helps to maintain an accommodative corporate financing environment and also to firmly support private-sector economic activity from the financial side. Even when there were strong concerns about financial system stability, financial markets were stable, the financial environment remained accommodative, and a possible credit crunch was avoided. This combination of market stability and the accommodative financial environment also played a major part in preventing the economy from falling into a deflationary spiral of price declines, deterioration in corporate profits, and contraction in economic activity. Portfolio rebalancing by financial institutions holding current accounts at the Bank, which involves shifting large amounts of surplus funds from non-interest-bearing current accounts at the Bank into other interest-bearing assets, has been pointed out as a possible effect of raising the target for current account balances under the quantitative easing policy, although there has been little evidence of it to date. The second element of the policy framework is the Bank's commitment, unprecedented in the history of central banks, to continue this policy until the year-on-year rate of change in the CPI (excluding fresh food, on a nationwide basis) registers zero percent or higher on a sustainable basis. This commitment leads market participants to expect short-term interest rates to remain at zero for longer. The result is to keep longer-term interest rates steady at low levels, underpinning corporate profits, and improving the return on investment. Within a financing environment where they can raise funds at low rates even while the economy continues to recover, firms will pursue new business opportunities more vigorously and adopt a more proactive business stance, thereby raising expectations of economic growth. At the Monetary Policy Meeting (MPM) on May 19 and 20, 2005, the Bank decided to maintain the current guideline for money market operations, which specifies a target for the outstanding balance of current accounts at the Bank of around 30 to 35 trillion yen, and the Bank also decided to add the following sentence to the proviso in the guideline: "When it is judged that liquidity demand is exceptionally weak considering such factors as responses of financial institutions to the Bank's fundssupplying operations, there may be cases where the balance of current accounts falls short of the target." At the MPM on June 14 and 15, 2005, the Bank maintained the guideline in this form. The Bank decided to amend the proviso in the guideline because financial institutions' demand for liquidity has been declining, reflecting abatement of concern over financial system stability, and there has been a stronger feeling that liquidity in financial markets is in abundance. As a result, undersubscription, where financial institutions' bids fall short of the Bank's offers, has occurred frequently in funds-supplying operations. If the Bank tries to keep the outstanding balance of current accounts at the Bank within the target range even when liquidity demand has declined substantially, 5/6 this could, depending on the means employed, have negative effects on the functioning of financial markets, for example, by distorting interest rates. Given this situation, the Bank decided to maintain the current target range of "around 30 to 35 trillion yen" but also to allow the balance of current accounts to fall short of the target in cases when liquidity demand was judged to be exceptionally weak. Although this decision was made merely as a response to the decline in financial institutions' demand for liquidity which has accompanied increasing confidence in financial system stability, some market participants have instead interpreted it as a step toward termination of the quantitative easing policy. I would like to stress that there has been no change in the Bank's underlying policy of maintaining the target range of "around 30 to 35 trillion yen," and that the decision at the MPM to add a sentence to the proviso in the guideline was definitely not an indication of a shift in the quantitative easing policy. Instead, it was simply intended to facilitate the smooth implementation of the quantitative easing policy by enabling the Bank to give due consideration to the functioning of the market mechanism in its liquidity provision. As for the future conduct of monetary policy, the Bank will firmly keep in place the current quantitative easing policy framework detailed earlier with the commitment based on the CPI. Although the timing of a change to the quantitative easing framework is not certain at present, if current projections regarding economic activity and prices in fact materialize, the possibility of a change in the policy is likely to gradually increase over the course of fiscal 2006. As long as upward pressures on prices continue to be to a large extent contained and the economy follows a sustainable and balanced growth path, this will likely give the Bank latitude with regard to changes in the policy framework and the subsequent conduct of monetary policy. Based on this thinking, the Bank will continue to conduct monetary policy in an appropriate manner giving due consideration to changes in economic activity and prices, as there is uncertainty with regard to their future developments. 6/6
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Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the Forum on Retail Financial Services, Tokyo, 21 July 2005.
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Toshihiko Fukui: New trends in financial services - creation of innovative retail services Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the Forum on Retail Financial Services, Tokyo, 21 July 2005. * * * Introduction It is a great pleasure for me to speak at this forum about a topic, retail financial services, which is indeed of great interest to central bankers around the world. Retail financial services have just entered a new stage of development in Japan. This is evident, for example, in the fact that an increasing number of banks are allocating substantial management resources to various areas of retail financial services. Behind this movement is a business strategy among banks to strengthen their profitability, now that the nonperforming-loan (NPL) problem has been nearly overcome. Enhancement of retail financial services, however, is not a trend seen only in Japan, but it has been a common feature in financial industries worldwide since the 1990s. In the sessions to follow at this forum, experts and practitioners in retail financial services will discuss the details of their business in Japan. In my speech today, I would first like to talk about significant changes in the structure of the world economy and financial markets that are behind the increased emphasis on retail financial services. I will then proceed to a discussion of the key factors necessary for the sound and robust development of retail financial services in Japan, focusing on financial services for individual customers. I. Background of the Increased Global Emphasis on Retail Financial Services A. Changes in Corporate Behavior Since the early 1990s, industrial countries have faced a period of fierce competition. This has been fueled particularly by economic globalization and the rapid progress in IT, which together have lowered barriers both in time and distance. Now we frequently see companies with a successful business in one country being challenged by foreign competitors and rapidly losing their competitiveness. The difficulty in projecting future economic developments, together with the geographic expansion of the market and the shorter life cycle of products, have provided firms with new business opportunities, but also resulted in increased uncertainty for corporate management. Given the changes in the business environment that I have just noted, firms are increasingly aware of the need to improve their financial strength in regard to executing management or investment decisions, to overcome such uncertainties. In other words, it is evident that a growing number of firms, both at home and abroad, are increasingly mindful of the size of their debt obligations and undertaking investment decisions in a very cautious manner. Reflecting such behavior, the ratio of corporate free cash flow to GDP is at historically high levels in both Japan and the United States. This does not necessarily mean that firms are adopting a conservative management stance, but that they are seeking a greater degree of flexibility in carrying out capital investment or participating in mergers or acquisitions when they find a profitable line of business. B. Changes in Household Behavior The environment for household financial behavior is also changing. Interest rates in industrial countries are at historically low levels against a background of modest inflationary expectations. Interest income from low-risk assets, such as government securities and bank deposits, is also at low levels. In order to achieve robust and sustainable national economic growth amid the fierce global competition that I mentioned earlier, it has become critically important for a provider of funds to select promising firms with cutting-edge business opportunities and extend financial support to their business activities. A nation's wealth will grow if investors, including households, can succeed in choosing promising firms with healthy prospects, and provide financial support and bear part of their risks through investment in various financial products. In other words, the financial behavior of individuals determines the future of a nation's economic growth, which in turn decides their own future welfare. C. Response of Financial Institutions Structural changes in the global economy and financial markets have had a significant impact on the business model of financial institutions. With the management stance in the corporate sector that I have described gaining ground among firms, it has become difficult for financial institutions to earn high profits from large corporate customers through transactions such as lending and underwriting of corporate bonds. Furthermore, a change has occurred in the balance between the intermediary function played by financial institutions and that by markets, as a result of the development of capital markets and increased disclosure of corporate information. In other words, large firms and institutional investors are now in a much better position to directly satisfy their financial needs through markets. In light of these developments, the growing trend among financial institutions around the world is to strengthen lines of business pertaining to individual customers. This move makes economic sense in that this category of customers is usually able to obtain less financial information than other categories and is thus more dependent on standard financial services, such as loans, deposits, and investment trusts, provided by financial institutions. Thus, there is greater scope for financial institutions to play a large intermediary role. Another factor underlining this trend is banks' need to control their risks. Both Japanese and foreign banks, which have experienced the NPL problem, are increasing their share of small-sized loans extended to households in order to diversify the risks of their loan portfolios. In addition, personal loans such as residential mortgage loans can be easily off-balanced or securitized thanks to advances in financial technology. Furthermore, it should be noted that financial institutions can reduce their own risks by providing a wide range of financial products and services to households with appropriate support, such as close investigation of risk profiles of corporate businesses and comprehensive explanation of financial products to households. This is because such an active intermediary function of financial institutions can lead to steady channeling of part of household funds toward firms with high growth prospects. D. Deregulation Besides the structural changes in the economy, there are at least two additional factors accelerating financial institutions' efforts to strengthen retail financial services. The first is financial deregulation. Since the 1990s, authorities around the world have steadily eased or abolished regulations that separately governed the businesses of banking, securities, and insurance. The relaxation of the segregation rules that used to restrict financial services providers to offering only their specialized lines of business has opened the way for "one-stop-shopping," in which a single institution can provide integrated financial services. This change is clearly for the better. Besides offering greater convenience to customers, it generates an incentive for financial institutions to benefit from the effects of synergy. Many financial institutions are aiming to realize the benefits of synergy through mass sales of standardized products in the area of retail financial services. It is interesting to note that in order to profit from synergy, financial institutions around the world are adopting two seemingly opposing policies--"consolidation of business" and "division of labor"-simultaneously, with each complementing the other. In Europe, there exists a tendency favoring financial conglomerates, comprising the banking, securities, and insurance affiliates, in an attempt to take great synergy profits. Large establishments, however, tend to be slow to react to changes in the environment. Across national boundaries, therefore, there is a movement toward "division of labor" among financial institutions, which should enable them to rapidly meet the diversified needs of customers. The policies being adopted here appear to be strengthening the lines of business where one enjoys a comparative advantage, while opting for outsourcing or a business alliance where there is no such advantage. E. Innovations in Financial and IT Technologies The second factor accelerating financial institutions' efforts to strengthen retail financial services is the remarkable progress in recent years in financial and IT technologies, which together have had a tremendous impact on the conventional thinking in the financial industry. Previously, small financial institutions with strong local ties excelled in loans to individual customers and other retail financial services, while large financial institutions considered such business less profitable relative to its costs. Retail transactions, compared with corporate transactions, involve far greater numbers of customers and correspondingly large amounts of data, and require a large number of competent employees at branch offices to provide various financial products and services. The progress in IT, however, has made it much easier to process massive amounts of data efficiently. Furthermore, financial institutions have now introduced an efficient method of credit screening using statistical models based on probability theory and drawing on accumulated customer data. This is quite unlike the previous practice, in which each and every loan application had to be individually examined. Another change appears in the area of sales. Banks used to "respond" to the needs of customers when the latter visited bank premises. Now, however, banks are "proactive," drawing on customer data compiled on the basis of age, sex, and other criteria. Such data allow them to better grasp customer needs and develop potential business. Customer contact through direct mail may result from such analysis. II. Special Features of Retail Financial Services in Japan As I have described, moves to strengthen retail financial services can be observed throughout the industrial countries, but the United States and Europe have taken the lead, far outpacing Japan, which has been burdened by the NPL problem for an extended time. Within the Japanese financial industry hereafter, it will be necessary to establish high-quality financial services for individuals and households, taking the special features of retail financial services in Japan into account. I will now point out these special features. A. Customers' Preference for Access to Financial Services through Bank Premises First, individual customers in Japan show a strong preference for access to financial services through bank branch premises, given that the level of administrative work at Japanese banks is relatively high among banks worldwide. This implies that the network of bank branches in Japan is of extremely high value as a distribution channel for various financial products and services. Under these circumstances, in meeting the financial needs of individuals, it would be extremely effective if the providers of various financial services utilized the network of bank branches as their sales channels for the financial products and services in which they specialize. For example, following the lifting of the ban on over-the-counter sales of investment trusts at banks in 1998, banks--not only major banks but also regional ones--have continued to expand sales of investment trusts, such that these over-the-counter sales account for approximately 40 percent of total investment trust sales at present. Naturally, this does not mean that all investment products are accepted by individual customers only because they are sold over bank counters. In the years just after the ban on investment trust sales was lifted in 1998, banks mostly sold low-risk-type investment trusts, such as money market funds, but sales growth during those few years was modest. Growth in stock investment trusts for the last couple of years, particularly the surge in monthly-distribution-type investment trusts that mainly purchase foreign bonds, has greatly expanded the sales volume at banks' counters. Investment trusts sold by affiliates within the banking groups has increased, but this does not seem to be the primary reason for the rapid growth. Rather, it has been due to a change in the sales strategy of independent mediumsized investment companies and foreign investment companies, which have no strong sales network of their own but have started to take advantage of the sales power of bank branches. Such investment companies developed products that would be suitable for bank customers, such as monthlydistribution-type products, and also provided bank staff with training on how to sell the investment trusts. I think the key to developing innovative retail financial services hereafter in Japan will be how to meet the needs of individual customers by establishing an efficient division of labor within the financial services sector overall, making full use of the effectiveness of sales channels, namely, the network of bank branches. B. Competitors Other than Private Financial Institutions The second special feature in Japan, in the field of financial services for individual customers, is the relatively large presence of nonbanks and public financial institutions in comparison with private banks. For example, nonbanks specializing in consumer finance have a significant share of business dealing with the borrowing needs of individual customers. In addition, even in the area of credit cards, affiliates of retailers such as supermarket chains and independent commercial companies have shown their own strengths in revolving credit. Banks have tried to challenge nonbanks by providing loans with lower interest rates than nonbanks, taking advantage of their low fund-raising costs and solid branch networks. Nonbanks, however, have established a competitive advantage in loan collection expertise and consumer credit data, and have even fully worked out their distribution channels by introducing automated contracting machines. Such competition is behind the recent marked movement toward capital and business alliances between major banks and nonbanks. There have also been efforts to boost administrative efficiency by sharing back-office functions among several credit card companies, including those of bank affiliates. Next, in the field of residential mortgage loans, the Housing Loan Corporation (HLC) has been playing an important role. This public corporation once held the largest market share for residential loans in Japan, but following the government's decision to implement a gradual contraction of its operations in 2001, the private sector has taken aggressive action in this market, and a substantial amount of residential loans has shifted to the private sector. Furthermore, the competition among private financial institutions has increased the variety of loan products, and loan interest rates have actually declined. The HLC now undertakes operations that are difficult for the private sector to initiate immediately, for example, selling 35-year loans at a fixed interest rate through the branches of private financial institutions and securitizing those loans by itself. Thus, I think the change in the HLC's role has provided the private sector with a new business opportunity and led to an enhancement of the level of financial services for individual customers with public institutions complementing private-sector services. Considering the steady expansion in sales of government securities for individuals through the post office networks, I think Japan Post (JP) can serve as a distribution channel for financial products to individuals. At present, the postal privatization bills are under discussion in the Diet. In regard to the privatization of JP, we consider it especially important to secure a level playing field for competition with the private sector and to insulate risks between the business lines of JP, as we have pointed out up to now. C. Efficiency of Retail Payment Services The third special feature of retail financial services in Japan is that highly efficient retail payment services are being provided here. In the United States and Europe, personal checks are widely used for retail payments, such as utility bills and credit card payments. In Japan, on the other hand, direct debiting/crediting using bank accounts is widely used. Furthermore, transfer instructions sent via the Internet are also increasing. Given that such efficient retail payment services have long been available in Japan, people tend to consider that these services are public goods like water and air, and do not seem to fully recognize the risks and costs associated with these services. In fact, direct debiting/crediting using accounts across financial institutions, for example, bears some settlement risks until final settlement, and incurs administrative costs. Checking accounts are frequently used in the United States, but not everyone can write a check, nor can they do so every time they want to. In contrast, in Japan ordinary deposits allow payment transactions on an unlimited basis while bearing interest. Taking this feature into account, ordinary deposits in Japan are indeed a value-added financial service. As implied by this case, it is important for Japanese financial institutions to earn rational profits from the day-to-day retail payment business. Concurrent with the progress in IT, there has been an increase in financial crimes not seen previously. At the same time, households are demanding greater information security from financial institutions in addition to efficiency in transactions. For the financial system to function stably, it is necessary for each financial institution to take appropriate measures to ensure information security. At the same time, I think such efforts to ensure information security can be an important key to differentiating the quality of "invisible" payment services and thus allowing the setting of rational charges. III. Toward Further Development of Sound Retail Financial Business A. Policy Issues Let us next consider the significance of further developing financial services for individuals in view of overall economic activity and social welfare. First, meeting the financial needs of households more efficiently by providing a wide range of retail financial services not only supports the economic activity of households, but also, by channeling part of household funds stably to various firms, contributes to future growth in the Japanese economy as a whole. Second, it contributes to enhancing the robustness of the Japanese financial system. It cannot be denied that, in Japan, financial assets held by households have been concentrated heavily in deposits, and this has caused the concentration of various risks at banks. If households were to hold assets of varying types of risks, the risks borne by banks would be reduced, thus enhancing the robustness of the financial system. To achieve this result, some call for policies to induce a shift of household assets "from savings to investment." However, the asset portfolios of households cannot be changed significantly merely by imposing a one-sided risk transfer from financial institutions. It is important to encourage households to voluntarily take on risks suitable for their own risk preferences. To this end, financial institutions should provide products and services that meet the financial needs of households through appropriate channels concurrent with full explanations of the risks. Finally, I would like to discuss policy issues related to inducing the creation of innovative financial services for individual customers. B. Ensuring Sound Competition First, in order to encourage the creation of retail financial services that accurately meet the various needs of households, it is necessary to ensure sound competition among financial institutions. However, in the past, the government and the Bank showed extreme care in handling even a small sign of instability within the financial system, bearing in mind that it could generate systemic risk and damage the stability of the entire system. However, in the course of the last ten years, we have seen the firm establishment of a safety-net system necessary for handling such situations as the bankruptcy of a financial institution, and the government and the Bank have accumulated practical experience in dealing with such emergencies. Furthermore, financial institutions have now nearly overcome the NPL problem, and from April 2005 the blanket guarantee of deposits was fully lifted without any disruption. Considering this situation, in order to promote the sound development of the Japanese economy, I think it is appropriate to shift the main focus of policies regarding the financial system from crisis management to strengthening the financial function. Enhancement of financial functioning is strongly needed also in retail financial services. For example, complicated financial products that require a high level of knowledge are increasing. In this situation, financial institutions are expected to fulfill their function by providing individuals with easy-tounderstand product information, and adequately transforming complicated products into easily understood ones. To this end, a key policy issue will be to secure an environment that allows free competition among a wide range of financial institutions, including public ones, to promote innovations in improved financial products and services. C. Solidifying Mutual Trust between Financial Institutions and Households Another key policy issue is to establish a relationship based on enhanced mutual trust between financial institutions and households. Between financial institutions and households, there exists an extremely large disparity in financial knowledge and amount of access to relevant information. In addition, financial institutions store a massive amount of personal information. From a policy perspective, therefore, it is extremely important to minimize harmful influences stemming from this information disparity and information concentration, and to encourage voluntary measures by financial institutions to contribute to a relationship with customers based on enhanced mutual trust. Considering the high possibility that various types of financial institutions, including companies other than banks, will become involved in a wide range of financial services, a relationship based on enhanced mutual trust with individuals becomes all the more important. Mutual trust should be reinforced in various stages of intermediary functions, such as during the development of financial products, sales, and asset management. I would like to emphasize two points indispensable to that end. My first point concerns the way to protect investors. The current framework for investor protection in Japan is not based on the nature of the product or service, but stipulated according to segmentation of the business, for example, banking, securities, trust banking, and life insurance. To improve this structure, introduction of a unified framework based on an investment services law is currently under discussion. For providers of various financial services, the setting of unified obligations to protect investors will be the minimum requirement. However, here I would like to emphasize that the aim should not be a regulation which enumerates detailed obligations issue by issue. What is needed in the new legal framework for investor protection is to clarify the basic principles to be observed by financial institutions, for example, to fulfill fiduciary duties such as faithful execution of investment instructions given, and segregated management of customers' assets. In addition, it is more important to provide a framework that encourages voluntary actions by the financial institutions themselves, to build a higher level of trust with customers. The driving force spurring financial institutions to take such actions is, simply speaking, market discipline. With the full removal of blanket guarantee of deposits, it is expected that depositors themselves will make a rigorous selection of financial institutions, but amid the increasingly diverse and complex range of financial products, market discipline will not work fully based merely on the selections made by depositors alone. It is necessary for all parties concerned to make market discipline function effectively. These parties include the shareholders of the financial institutions, the creditors, the stock exchanges that list the shares of the financial institutions, the auditors, the credit rating agencies, and the external directors of the financial institutions. In addition, market participants, not the supervisory authorities, should take the lead in the formation of market rules necessary for the practical functioning of market discipline. My second point is that it is necessary to secure a high level of information security. As mentioned earlier, extremely efficient retail payment services are provided in Japan, but as can be inferred from the recent cases of fraud involving various types of cards, the level of information security in financial transactions in Japan has not reached the top level globally. If technological capabilities in Japan are fully applied to enhance security, however, I believe that the Japanese financial industry is capable of providing security at the world-class level, while maintaining its efficiency. In other words, I would like to emphasize that we should not underestimate the importance of security issues in providing retail services, and leave problems pertaining to security unresolved, because this could eventually result in excessive nationwide regulation. This is also true for the financial industry. Therefore, regarding the security of financial information, I think it is extremely important for financial institutions to continually study cutting-edge technologies and provide tools and infrastructure to ensure security in a preemptive manner, before the public demands it of them. In this case, it may be sensible for the costs associated with provision of a high level of infrastructure to be allocated and borne appropriately between the financial institutions and end-users. At the same time, individuals need to have a clear idea of how to safeguard their personal information through their own efforts. We take various measures to prevent thieves from breaking into our home, but our awareness of how to protect ourselves against financial crime is relatively weak in comparison. Needless to say, in all transactions, we should ensure the safety of transactions by ourselves. Of course, on the part of financial institutions, it is necessary to encourage individual customers to adequately understand the measures that are indispensable for self-protection. Conclusion I have mentioned important points indispensable to the sound development of retail financial services in Japan. To reiterate, if financial institutions can provide various financial services that meet the needs of households, and through such actions, effectively utilize the funds of households to support corporate activity, it can contribute not only to increasing households' wealth, but also to promoting the economic growth of Japan. At the same time, through the reallocation of risks, this will contribute to enhancing the robustness of the financial system in Japan to counter external shocks. Considering that the Japanese financial system is regaining its stability, we at the Bank of Japan has taken a number of steps with the intention of contributing to developing and spreading advanced financial technologies through our functions of on-site examinations and off-site monitoring to encourage financial institutions' efforts to provide more advanced financial services. To this end, the Bank established the Center for Advanced Financial Technology in July 2005 within the Financial Systems and Bank Examination Department. The department was created by integrating the former Financial Systems Department and the former Bank Examination and Surveillance Department. In addition, from the perspectives of enhancing the functions of financial markets and settlement infrastructure, we are determined to make greater efforts together with market participants to enable market discipline to fully perform its function. In this respect, along with the organizational changes in July that I have mentioned, we established the Payment and Settlement Systems Department by making independent a part of the function performed by the Financial Markets Department. And with the aim of bolstering research on information security, at the start of April 2005 we established the Center for Information Technology Studies at the Institute for Monetary and Economic Studies. Through such measures, we aim to do our utmost to promote the steady development of retail financial services in Japan.
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Statement by Mr Toshihiko Fukui, Governor of the Bank of Japan, concerning the Bank's seminannual report on currency and monetary control, before the Committee on Financial Affairs, House of Representatives, Tokyo, 2 August 2005.
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Toshihiko Fukui: Review of Japan’s economy Statement by Mr Toshihiko Fukui, Governor of the Bank of Japan, concerning the Bank’s seminannual report on currency and monetary control, before the Committee on Financial Affairs, House of Representatives, Tokyo, 2 August 2005. * * * Introduction I am pleased to have this opportunity to present an overall review of the Bank's conduct of monetary policy. I. Developments in Japan’s Economy Japan's economy continues to recover, albeit with adjustments in IT-related sectors. In more detail, although the momentum of growth in exports, particularly to China, has been weak recently after the significant increases through the middle of 2004, industrial production is on a gradual uptrend as inventory adjustments in the IT-related sectors are progressing. Business fixed investment has continued to increase, as corporate profits have remained high and business sentiment has shown improvement again. Household income has been rising, albeit moderately, as the employment situation has been improving and wages have stopped declining. In this situation, private consumption has been steady. Based on these developments, it can be said that the economy is emerging from its temporary pause. As for the outlook, growth in exports is expected to accelerate gradually as overseas economies continue to expand, and domestic private demand is likely to continue increasing against the background of high corporate profits and the moderate rise in household income. The economy is therefore expected to follow a sustainable growth path, albeit at a moderate pace. On the price front, as the output gap continues to narrow, domestic corporate goods prices have been increasing, mainly reflecting the effects of the rise in crude oil prices. They are likely to continue on an increasing trend, but the rate of growth is expected to slow for the time being. Consumer prices (excluding fresh food) have basically been declining slightly on a year-on-year basis, partly due to the reduction in electricity and telephone charges against the background of such factors as deregulation, and they are projected to continue falling slightly for the time being. However, they are expected to start increasing on a year-on-year basis at some point in late 2005 or early 2006, as the effects of temporary factors, such as the decline in rice prices and the reduction in electricity and telephone charges, fall off. In the capital markets, stock prices have been firm on the whole and long-term interest rates have been stable. The environment for corporate finance is becoming more accommodative on the whole. That is to say, in a situation where the lending attitude of financial institutions is becoming more active, the rate of decline in lending by private banks has been diminishing at a moderate pace. Moreover, the environment in the capital markets for firms raising funds through CP and corporate bonds is favorable. II. Conduct of Monetary Policy The Bank has been providing ample liquidity through its conduct of the quantitative easing policy. The framework of the quantitative easing policy is based on two key elements. The first element is the Bank's provision of ample liquidity to the money market so that the outstanding balance of current accounts at the Bank substantially exceeds the amount of required reserves. The second is the Bank's commitment to firmly maintain this ample provision of liquidity until the year-on-year rate of change in the consumer price index (CPI; excluding fresh food, on a nationwide basis) registers zero percent or higher on a sustainable basis. At the Monetary Policy Meeting (MPM) on July 27, 2005, the Policy Board decided to maintain the target range for the outstanding balance of current accounts held at the Bank at "around 30 to 35 trillion yen." In the money market, reflecting the dissipating concern about financial system stability, liquidity demand among financial institutions has been declining and they are feeling more strongly that there is an abundance of liquidity. Given this situation, since the MPM held on May 19 and 20, 2005, the Bank has been allowing a temporary fall of the outstanding balance below the target range when it is judged, in the situation where the Bank is doing its utmost to provide funds while at the same time giving due consideration to the effects on the functioning of the market, that financial institutions' liquidity demand is exceptionally weak. The Bank's decision is intended to enable the quantitative easing policy to be conducted more smoothly, not to change its basic policy stance. III. The Bank's Measures regarding the Financial System after the Full Removal of the Blanket Guarantee of Deposits As I mentioned earlier, the financial system in Japan has been regaining stability, and the full removal of the blanket guarantee of deposits was carried out smoothly on April 1, 2005. Financial institutions are expected to amplify their efforts to develop innovative services tailored to customer needs, thus supporting economic activity. The Bank's basic stance regarding financial system policy is shifting its focus in response to this changing environment: from crisis management to, while maintaining overall system stability, supporting private-sector initiatives to provide more efficient and advanced financial services through, for example, improved management of risks and business activities. In order to contribute to enhancing the functioning and robustness of the financial system, the Bank will actively encourage financial institutions' efforts to improve their business activities, and devise various ways to enhance its own business operations. Conclusion Japan's economy continues to recover in a situation where overseas economies continue to expand. As for the outlook, it is expected to move onto a path of sustainable, albeit moderately paced, growth. The Bank will continue to carefully watch changes in the economic environment and will conduct monetary policy in an appropriate manner. In the current situation where the CPI remains on a slight downtrend, the Bank is determined to support Japan's economy from the financial side to achieve sustainable economic growth with price stability, by maintaining monetary easing in accordance with the commitment based on the CPI. In addition to its efforts in conducting monetary policy, it has become increasingly important for the Bank to pursue more advanced services in a wide range of areas as well as ensure well-disciplined management to properly carry out the duties entrusted to it as the nation's central bank. In light of this, the Bank has formulated a Medium-Term Strategic Framework (MTSF) for fiscal 2005-2009, which sets out the Bank's management policy for the next five years. The Bank is committed to continuing its efforts, through the steady implementation of this MTSF, to retain public confidence and fulfill its mission of contributing to the sound development of the economy.
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Summary of a speech given by Mr Kazumasa Iwata, Deputy Governor of the Bank of Japan, at the Panel Discussion 'Monetary Policy Strategies: A Central Bank Panel', at the Symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 27 August 2005.
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Kazumasa Iwata: The role of the price stability anchor in extricating Japan from deflation Summary of a speech given by Mr Kazumasa Iwata, Deputy Governor of the Bank of Japan, at the Panel Discussion “Monetary Policy Strategies: A Central Bank Panel”, at the Symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 27 August 2005. * * * Introduction I would like to talk about the issues relating to monetary policy strategies for the future, in the light of Japan's experience in the last decade of stagnation as well as deflation, and the subsequent struggle to overcome deflation under the zero bound on the nominal interest rate. After a pause in growth triggered by the bursting of the mini-bubble in the digital electronics sector in spring 2004, Japan has resumed growth exceeding the potential growth rate, with the rate of change in the consumer price index, excluding institutional and special factors such as oil, telephone charges, rice and fresh food, registering virtually zero in recent months.1 Currently we have good prospects to exit from a decade-long period of deflation. In this context, I would like to draw some lessons from previous policy developments for the future conduct of monetary policy, focusing on the role of the price stability anchor. The quantitative easing policy and the price stability anchor Japan is apparently viewed as a country that has not adopted an inflation targeting policy. Yet it is my personal view that Japan implements implicitly a price stability target within the framework of current quantitative easing policy (bank reserve target policy) which was introduced in March 2001. This is primarily because of the strict observance of the commitment on the policy duration to secure price stability. The preceding "zero interest rate policy" in the period from February 1999 to August 2000 failed to bear fruit, in part due to the weak commitment on policy duration. In contrast, under the quantitative easing policy, the Bank of Japan clarified and strengthened the commitment on the duration of the policy by presenting in October 2003 the three conditions for ending this policy. The three conditions can be summarized by a phrase such as "stably above zero of the core consumer price index on a year-to-year basis" or "never return to deflation." This commitment sends a signal to the market that the Bank of Japan finds it important to secure price stability to achieve positive inflation rates, although the numerical upper limit is not announced.2 It serves as an anchor of price stability to prevent a deflationary spiral under the condition of the zero bound on the nominal interest rate. Japan's economy resumed its recovery process after a pause in growth triggered by the IT sector-related inventory stock adjustment. The bursting of the mini-bubble in the digital electronics sector was associated with the downward cyclical phase of the liquid crystal and silicon cycle initiated in spring 2004. Subsequently, a non-IT sector-related inventory stock adjustment due to the deceleration of exports, notably for China, curtailed industrial production activity and the growth rate. Currently, the inventory stock adjustment process is almost over. In addition, domestic private final demand in the first half of 2005 was sufficiently strong to register growth above the potential growth rate (about 1 percent). On the lack of an upper limit, there is some similarity to the lack of a lower limit for the numerical definition of price stability below 2 percent during the initial stage of monetary operations by the European Central Bank. 1/5 Price level indeterminacy under the zero bound on the nominal interest rate Under the Bank of Japan's quantitative easing policy, not only the uncollateralized overnight call rate but also the rate of longer maturity of at least one year has virtually reached zero. It is well known that monetary policy aimed at fixing the market interest rate faces difficulties in controlling the money supply and the inflation rate. The difficulties are augmented under the zero interest rates, because the association between the money supply and the price level becomes much looser than normal. Therefore, it is all the more important for the central bank to provide the price stability anchor to the market.3 Moreover, the zero bound on the nominal interest rate erodes the market mechanism in the financial market as well as market discipline, thereby distorting the allocation of funds on the market. In the past several months, we encountered a difficulty in achieving the bank reserve target due to undersubscription to our offers in open market operations, and allowed a temporary deviation from the lower limit of the reserve target in early June, end-July, and early August. The intention was to maintain the bank reserve target in the face of diminishing demand for excess reserves by banks. In other words, the measure was designed to solve the trade-off between strict implementation of the commitment and flexibility. It may be noted that the additional flotation of government bonds to frontload the rollover of existing government bonds concentrated in fiscal 2008 has made it more difficult to maintain the reserve target.4 Bank of England Governor Mervyn King (2004) once pointed out the importance of debt management policy, namely, the shortening maturity structure of government debt, to Japan's exit from deflation. The cash management by the government sector also seems relevant to facilitate the efficient implementation of monetary policy. At any rate, it is best to preempt the emergence of the zero bound on the nominal interest rate, even though room remains for the central bank to affect the expected future path of short-term rates by implementing the commitment on policy duration longer than is usual. However, strict implementation of the commitment tends to limit flexibility in conducting monetary policy. Effect of quantitative easing policy on interest rates A number of proposals have been made to overcome Japan's deflation. One of them recommends widening the application of zero interest rates to longer maturity until the deflation disappears. In the process of raising the bank reserve target, the extent of zero interest rates has been widened to cover at least one year. This effect arises due to the commitment to maintain an ultra-expansionary policy longer than anticipated by the market participants under normal circumstances. We name this the "policy duration effect." The increase in the bank reserve target seems to have exerted a signaling effect to solidify the commitment and thus strengthen the policy duration effect, aside from the ample liquidity The ECB redefined price stability by adding a lower limit of 1 percent, yet the final goal is set closer to 2 percent. It may be noted that in Japan all the market interest rates are not zero, in contrast to the assumption adopted by several theoretical models. The amount of government deposits and government surplus in the Bank of Japan accounts is about 35 trillion yen, in part due to the frontloading of rollover of existing government bonds and the increase in tax revenue. Inefficient cash management arising from rigid accounting rules results in a significant revenue loss. Moreover, the fluctuation of budgetary funds in Japan is quite large, compared with other major countries. This tends to limit the capability to implement an ultra-easy policy. 2/5 provision to avoid systemic risk and a deflationary spiral. Both of the effects worked to support the recovery and prompt the restructuring process of debtor companies under the strain of balance-sheet adjustment, through the maintained low interest rates. The price stability anchor implicit in the commitment is not specified in terms of a time frame, but is highly data-dependent, as it is defined by the achievement of positive inflation rates. Market participants, who once appeared to be skeptical of our scenario of registering a 0.3 percent rise in the core CPI in fiscal 2006, now seem to anticipate the likely end of the current policy regime within one year, as observed in euroyen futures market interest rates. This has led to a pickup in interest rates over a wide range of maturities. In this sense the market informs us when the exit is coming. President of the San Francisco Federal Reserve Janet Yellen once asked me why deflation has subsided despite the existence of the output gap. My answer was, "It is because of the speed limit effect." The narrowing output gap was brought about by the lengthy and sustained recovery phase in and after 2002. It may be noteworthy that the effect of the speed limit (narrowing the output gap) dominated the effect of the level of the output gap on the deceleration of deflation.5 Now we have reached the stage where it can be said that a long time is not needed to satisfy the conditions to end the quantitative easing policy. Dynamic price stability target policy To the extent that the combination of the provision of the price stability anchor with the monetary easing policy based on our clear commitment has succeeded in bringing Japan's economy to a virtually zero inflation rate, compared with deflation of the core CPI of about 1 percent in 2001, it seems reasonable to maintain the key elements underlying the quantitative easing policy framework at succeeding stages. About two years ago, I described the step-by-step approach to attain ultimate price stability as a "dynamic price stability target policy" for extricating Japan from deflation, in contrast to the "timeless perspective" price level target policy. I identified the three phases of the dynamic adjustment process moving out from the deflationary equilibrium to the normal equilibrium, thereby avoiding the over- and undershooting of the inflation rate and the longterm interest rate, notably during the transition period. Recently, former Federal Reserve Governor Laurence Meyer (2005) has presented a threestep strategy for the future of Japan's monetary policy. He identifies three phases: namely, the quantitative easing policy, the zero interest rate policy, and the interest rate policy. In between, there are two transitional phases: One is dismantling the bank reserve target to the required reserve level (about 6 trillion yen), or the shrinkage of zero interest rates to the uncollateralized overnight call rate. Another is raising short-term interest rates to the neutral level to achieve price stability over the longer term. I personally find it desirable to provide an appropriate anchor of price stability in numerical form when we embark on a new policy regime such as the return to the zero interest rate policy. It seems necessary to retain the transparent commitment on policy duration in order to prevent abrupt changes of long-term interest rates in the transition process to reach a new In Japan, the output goal is not explicitly stated in the newly established Bank of Japan Law of 1997, in contrast to the case of the United States, where the dual mandate of maximum employment and price stability is prescribed in the Federal Reserve Act. Yet it is absolutely necessary to pay due attention to the movement of the output gap, notably the size of narrowing of the deflationary gap. In the process of overcoming deflation, the output goal may not be in serious conflict with the goal of price stability. 3/5 equilibrium, with the risk of entailing inflation (overshooting) or deflation (undershooting) being preempted.6 Dynamic price stability target policy and the timeless perspective policy The dynamic price stability target policy is "strategically coherent" (to borrow a phrase from Professor Bennett McCallum [2005]) to attain final price stability, but it is not a "timeless perspective policy" that puts emphasis on the time consistency of monetary policy.7 The price level target policy recommends achieving the prescribed path of price levels with a constant rate of inflation, regardless of the initial conditions. Yet it seems difficult to accept temporary overshooting of the inflation rate and long-term interest rates in the transition path returning to the desired price level path from persistent deflation, in particular under the circumstances of the large-scale accumulation of government debt and the persistent budget deficit in Japan. However, we recognize the importance of "history dependence" in conducting monetary policy. In this context, I would like to stress that maintaining the same reserve target level at the current stage implies an increased degree of monetary easing, since the excess supply of bank reserves is intensified and the maturity of short-term monetary operation instruments is lengthened, with the result of extension of zero interest rates in the market. Moreover, according to several surveys, the expected inflation rates turn out to be positive in recent periods. This implies that the short-term real interest rate is negative despite the zero bound on the nominal interest rates. If the core message of "history dependence" implies that the monetary policy effect becomes more expansionary at the point close to the exit, the Bank of Japan's current policy is in line with the spirit inherent in the price level target policy. The role of fiscal policy Let me conclude my remarks by referring to the role of fiscal policy to extricate Japan from deflation. We observe that the government announced the fiscal policy target to achieve a primary budget deficit of zero in about ten years, and the automatic stabilizer effect dominated fiscal policy management after 2001 under the Koizumi administration. The coordination between monetary and fiscal policy becomes more important, if the economy were to fall into deflationary equilibrium (or the Friedmanian equilibrium), where the size of deflation rate is equal to the natural interest rate. On fiscal policy, we can identify the two different types; namely, the Ricardian and the non-Ricardian. If the present value of government debt in the future becomes zero regardless of changes in the path of prices, it is classified as a Ricardian policy. This implies that we should have some safety margin on the final numerical objective (aside from the bias inherent in the price index), given the likely negative macroeconomic shock to the lower natural interest rate of Japan's economy over the future which is conducive to the zero bound on the nominal interest rate. This issue may be related to issues such as the discretion versus rule-based policymaking, or the risk management approach under uncertainty versus rule-based policymaking. It seems sensible to adopt the risk management approach under the Knightian uncertainty (Greenspan [2004]). Chairman Greenspan is critical of the "too inflexible" management of rule-based monetary policy. Yet "activist" rule-based policymaking seems to possess sufficient flexibility in uncertain circumstances. For instance, the Bayesian decision process under the risk management approach involves a learning process. Learnability plays an important role in ruleoriented monetary policy to secure stability of the equilibrium. Rule-based monetary policy has flexibility to implement a systematic revision of a contingent plan and prescribes the updating process in a "timeless manner," while discretionary policy revises a contingency plan period by period. In any case, there may arise no conflict or inconsistency between the risk management approach and the provision of the price stability anchor to market participants. 4/5 As long as the fiscal rule aiming at reducing the primary budget deficit over the medium term implies a moderate increase in the nominal government bond supply, then fiscal policy that is passive (or Ricardian) under the normal equilibrium with a positive rate of changes in prices becomes active (or non-Ricardian) under the deflationary equilibrium. Thus, there is a good reason to expect that the gradual consolidation of the fiscal balance facilitates the economy's exit from deflation, coupled with a monetary easing policy based on the price stability anchor. 5/5
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Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the 2005 IIF Annual Meeting, Washington DC, 25 September 2005.
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Toshihiko Fukui: Reflections on what is happening in the global economy today Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the 2005 IIF Annual Meeting, Washington DC, 25 September 2005. * * * Introduction It is a pleasure to appear before you this morning and share my thoughts on what is happening in the global economy today. Before I go any further, let me express my deepest condolences for the great suffering caused by Hurricane Katrina just a few weeks ago. My remarks will be divided into three parts. In the first, I will comment on the currents of structural changes in the global economy from a long-term perspective. Against the backdrop of these changes, I would then like to say a few words on the changing role of the International Monetary Fund (IMF)--a medium-term issue for all of us in this room. Finally, I will comment briefly on a conjunctural issue--the state of the Japanese economy and the monetary policy of the Bank of Japan. I hope to answer a few questions, if we have time before I have to head to Dulles Airport to catch my plane to Tokyo. Structural changes in the global economy The global economy has undergone significant structural changes in the last decade. Of those changes, in my view, three are most important. The first is the entry of emerging market economies into the market-based economic system. The second is the progress we have observed in information, communications, and telecommunications (ICT) technology. The third is the aging of the population, especially in mature industrialized economies. Let me take up these developments in turn. Since the 1990s, emerging market economies--China, India, and countries in Central and Eastern Europe--have progressively been integrated into the market-based economic system. Taking advantage of their relatively low wages and foreign direct investment (FDI) and technology transfers from mature industrialized economies, these countries have increased their supply of goods and services to the global economy. In this process, these countries have broadened their exports as well. They are now exporting not only light industry products, such as textiles, but also heavy and high-tech industry products. Exports now also include services, such as operating call centers. The advances in ICT technology, such as the widespread use of the Internet, have significantly reduced the costs of processing and transmitting information. This has, in turn, enabled firms to expand their operations globally. Production of goods and services is now spread out over many economies. At the same time, ICT technology has also enabled firms to enhance efficiencies of so-called middle-management functions, resulting in the flattening of corporate organizations. The confluence of these developments with the integration of emerging markets into the market-based economic system has reduced the costs of doing business worldwide, and enhanced competition in the global marketplace. Meanwhile, the importance of the third structural change that I just mentioned--the rapid aging of the population especially in the industrialized economies--is just beginning to sink in. We now realize that the shift in demographics may have profound effects on various aspects of the global economic system. For example, it may change the savings-investment balance; it may change flows of money through financial intermediaries; and it may influence asset allocation among investors. 1/6 Today, I have chosen to focus on these issues, because various developments in the global economy--sometimes puzzling developments--flow out from these changes. One is the subdued rate of consumer inflation, which has defied extremely elevated price levels of commodities and raw materials such as crude oil. Another is the relative stability of long-term interest rates. At the end of August, crude oil prices reached US$70 a barrel. Though prices have come off the peaks, this starkly illustrates the rapidly rising prices of commodities and raw materials. Factors such as political unrest in producer countries and bad weather have certainly influenced such developments. Looking at crude oil, production capacity for petroleum products is constrained, because not enough money was invested in exploration, extraction, and refining in the wake of collapsing prices after the Second Oil Crisis. Nevertheless, the most significant factor seems to be the tightness in supply and demand conditions caused by strong demand. In particular, the combination of relatively high growth and relatively inefficient energy use in emerging market countries seems to be contributing to higher than expected growth in crude oil demand. As I noted a few moments ago, emerging market countries are now being integrated into the market-based economic system. Being new members of the system, however, their economies are still evolving. There remain rigidities, such as price controls. Consequently, they are not able to use resources as efficiently as mature industrial economies. Given this environment, it seems we will have to live with higher prices of commodities and raw materials, at least for the time being. While input prices are thus rising, pass-through to output prices is rather limited. In fact, since the 1990s, we are observing significantly lower rates of consumer price index (CPI) inflation around the globe. Productivity growth in the corporate sector is providing some cushion. However, the most important factor behind this development is again the integration of emerging market countries into the market-based economic system. With increasing integration, more goods are brought onto the market. In turn, competition is enhanced globally, producers' pricing power is weakened, and consumers benefit from downward pressures on prices. Lower inflation is accompanied by smaller fluctuations of the economy. Not only are we seeing lower inflation rates, we are also seeing lower inflation volatility. The volatility of growth is also declining. The increasing importance of services, the demand for which is less volatile than that for goods, is one contributing factor. As individual firms take advantage of ICT in managing their output, economic activity at the macro level may see less fluctuation. At the same time, greater flexibility in products and labor markets may help firms adapt smoothly to changing business conditions. Obviously, factors other than structural changes have also lowered inflation and volatility of inflation and growth. Central banks have also contributed to enhancing stability. Independent central banks, pursuing price stability through monetary policy, have successfully tamed inflation. This has enhanced the credibility of monetary policy, and, in turn, stabilized inflation expectations. In financial markets, low and stable rates of inflation have led to lower long-term interest rates around the world. Since I do not wish to repeat Chairman Greenspan, I will merely say that the structural changes I have touched on today are definitely influencing interest rate developments. The three broad trends--globalization, ICT, and aging--will be sustained for some time. Considering that there are still millions if not billions of underemployed workers in emerging market countries, the integration process will probably continue for many more years. Since human ingenuity is unlimited, we will find new and innovative uses for ICT in the years ahead. Institutional changes to mitigate the effects of rapid aging have only just begun. 2/6 As a result of the interactions between these trends, we are sure to see economic developments that we would never have imagined before. We have no crystal ball to accurately identify the changes ahead of us or their consequences. This means that our wellbeing will only be maintained if we can efficiently and effectively adapt to the changing environment. We must monitor events closely as they unfold, and be ready to respond flexibly. I am optimistic that central banks can adapt to changing economic conditions, as they have done so over many years. The changing role of the IMF Structural changes are not confined to the real economy. The forces of globalization are influencing the international monetary system as well. Yesterday, at the meeting of the IMF Council, we discussed the results of the Strategic Review of the IMF, initiated by Managing Director, Rodrigo de Rato. Rodrigo's project was extremely helpful, drawing up a comprehensive list of issues that we have to address. The consensus on where we stand was already described by Gordon Brown yesterday, and I will not repeat it here. The Strategic Review was necessary and useful in defining what needs to be done today. It is, however, the first step. Sixty years ago, the Fund was created to maintain a network of exchange rates anchored on the U.S. dollar backed by gold. There was also a mechanism to facilitate adjustments. Member countries were obliged to enter into annual consultations. In this process, the Fund identified economic policies that would undermine the network of fixed exchange rates. The Fund then suggested remedies, and lent money if necessary to buy time for policy adjustments to take effect. If exchange rates really fell out of line with economic fundamentals, it was possible to tweak the rates. Fast-forward to today, and we no longer have fixed exchange rates, particularly between systemically important countries. As a result, policy advice from the Fund is losing the force and urgency it once had. At the same time, we are witnessing increasingly stronger and more mobile private capital flows. These flows are, of course, generally beneficial. Though it is hard to measure precisely, private capital has played a significant role in the robust investment-led growth of many countries. Private flows are not only getting bigger, they are getting more nimble. In the seventies and eighties, banks were the main financiers for emerging market economies. On the other hand, much of today's private capital flows are in the form of bond issues. Compared with banks, bondholders tend to react very quickly. Bankers cannot call a loan until it is due. On the other hand, when bondholders sense a problem brewing, they can sell their bonds immediately. If everyone heads for the exit at once, bond prices will collapse and exacerbate problems for the issuing country. There will also be coordination problems. You can cram a few dozen bankers into one room and cut a deal, but we cannot do the same for bondholders. No wonder that emerging market and developing countries tapping the international financial market sometimes feel so insecure and helpless. The welcome rug could be pulled quickly from under their feet, as many of them found out in the late 1990s. They can turn to the Fund for help, but private flows could even overwhelm the Fund. Fund quotas, essentially equivalent to paid-in capital, total about US$330 billion. This is only a fraction of global financial flows. In our recent efforts to reform the international monetary system, we have tried to deal with these changes. As I said a few minutes ago, the Strategic Review is an important milestone. Nevertheless, the recommendations will soon be overtaken by developments in the international financial landscape. The three trends I mentioned in the first part of my talk-globalization, ICT, and aging--will continue. This means that capital movements between 3/6 economies will accelerate, broaden and expand. The Fund must continue to evolve, if it is to remain relevant in tomorrow's international monetary system. Though we cannot predict the exact consequences of the structural changes, a general idea of what we can expect seems to be clear enough. If private flows become increasingly important, we should emphasize private solutions as well as public interventions. There are two significant developments in this context. One is the collective action clauses (CACs) in bond covenants, advocated by the G-10 countries in September 2002. Now almost all new international bond issues are governed by CACs. In the near future, when bonds without CACs are all retired, CACs would govern the resolution of sovereign debt crises. A typical CAC allows the terms of a bond issue to be changed with the consent of 75% of bondholders. This means that if a country cannot pay its debts in full, it needs to come up with a restructuring plan that satisfies 75% of the lenders. The clear and transparent rules also reduce the chances for holdouts or rogue investors to disrupt an orderly workout process. In turn, the market can more appropriately price the risks and costs of defaults. Another notable development is the "Principles for Stable Capital Flows and Fair Debt Restructuring in Emerging Markets," released about a year ago. I know that Managing Director, Charles Dallara and his colleagues at the IIF worked hard to see its publication. The Principles offer a framework for enhancing flows of information between borrowers and lenders. They also provide guidance for productive engagements between them. These improvements should enable lenders to assess and price risks more precisely, enhance the stability of flows to developing and emerging market countries, and facilitate resolution of problems when they occur. These developments, especially the Principles, would strengthen market discipline. Borrowing countries would be encouraged to improve their institutions and adopt sound economic policies. As a result, we should see fewer international financial crises. In the unfortunate and hopefully rare event that problems do arise, a borrowing country and private lenders can negotiate orderly settlements, under the framework of CACs. The public sector, including the Fund, would only be called on in the rarest cases, where the speed and magnitude of the problems might overwhelm efforts to formulate private solutions. What does this mean for the Fund? In terms of giving out policy advice, the Fund's role would be more relative. If private lenders become more important, borrowing countries would be inclined to listen to what the market wants. The Fund is facing formidable competition, but I think it can build on its excellent reputation. I am especially looking forward to the efforts currently underway to enhance the Fund's work related to financial issues. Meanwhile, as I noted a moment ago, Fund lending will be necessary only when there is a rapidly unfolding crisis of considerable magnitude. We should, therefore, consider if the current rules for releasing Fund resources could appropriately cope with such a situation. In the jargon of the Fund, this is a question of improving the rules for exceptional access. To say that the Board is responsible for approving such lending is sidestepping the question. Can the Board form a consensus quickly enough? Is the Board representative enough so that members can subscribe comfortably to its decisions? Who is going to be held accountable if something goes wrong? Answering these questions will tax our imaginations to the fullest extent, but we must not dodge them. Disasters do happen. Recent developments in the japanese economy Before closing my remarks, let me briefly speak on the Japanese economy and the monetary policy of the Bank of Japan. 4/6 If we put aside quarter-to-quarter fluctuations in the rates of growth, the Japanese economy has been on a recovery track for three and a half years, since the beginning of 2002. Nevertheless, from the summer of 2004, we had a period of sluggish growth in exports and industrial production. This pause in growth was brought about by the global adjustment in the ICT sector. The Bank of Japan stated all along that slower growth was temporary, and that the Japanese economy would eventually regain momentum. There were, however, concerns that Japan had slipped back into recession. Fortunately, recent developments seem to indicate that the pause in growth is finally over: the adjustment in the ICT sector is almost complete; domestic demand components, private capital investments, and household consumption in particular, are generally showing firm growth; and exports, which were flat for some months, seem to be regaining traction. I believe that this trend will be sustained for some time. The Japanese economy should remain on a moderate but enduring growth path, supported by both domestic and external demand. There are two particularly encouraging factors. The first is that Japanese firms are at last seeing the end to structural adjustments necessitated by the bursting of the bubble economy. For more than a decade, the Japanese economy was under the yoke of "three excesses"--excess capacity, excess employment, and excess debt. Japanese firms worked very hard to get rid of these excesses. They are now adopting new strategies that enhance efficiency and competitiveness. As a result, they are becoming more profitable. In fact, measured by the profits-to-sales ratio, Japanese firms are more profitable than they were in the end of the 1980s, at the peak of the bubble economy. Against this background, the growth of capital investment is relatively strong, not only at large manufacturing firms but also at manufacturing small and medium-sized enterprises (SMEs) and at non-manufacturing firms. The second encouraging factor is that households are increasingly benefiting from the recovery in the corporate sector. Employment is growing, and the jobless rate has dropped to a seven-year low of 4.4%. Looking past the headline numbers, we see even more encouraging signs. Until recently, Japanese firms hired part-time and temporary workers in order to keep labor costs in check. Today, firms are stepping up their efforts to hire permanent workers, against the background of improving profitability and thus business confidence. Consequently, employee income, which was depressed by the rising proportion of part-time and temporary workers, is rising moderately. The promising employment and income environment is firmly supporting personal consumption, in both goods and services. These trends in employment, income and consumption are expected to continue for the time being. Coming back to the broad trend, the Japanese economy grew by 2.7% in 2004 and is expected to grow by 2.0% in 2005 according to the Fund's World Economic Outlook (WEO). This is not as spectacular as the United States, which grew by 4.2% in 2004 and whose WEO growth forecast is 3.5% for 2005. Nevertheless, it is a respectable growth path compared to some other mature industrialized economies. I believe that this moderate growth trend can be sustained for some time. What does this mean for monetary policy? The Bank of Japan is maintaining the policy framework of quantitative easing. As you know, under this framework, the Bank supplies liquidity far in excess of required reserves, creating an environment where short-term interest rates stay very close to zero. Another element of our present policy framework is a firm commitment to maintaining that environment until year-on-year inflation, as measured by core CPI, is stably zero or above. 5/6 Currently, Japanese core CPI is still declining slightly, and the Bank of Japan steadfastly adheres to the commitment I have just explained. By doing so, we are supporting the Japanese economy's return to a stable and sustainable path of growth. Thank you for your attention. It has been a pleasure speaking to you. 6/6
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Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at a meeting with business leaders, Osaka, 29 September 2005.
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Toshihiko Fukui: Recent developments in economic activity and prices and the Bank of Japan’s conduct of monetary policy Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at a meeting with business leaders, Osaka, 29 September 2005. * * * Introduction Today I plan to focus on recent developments in economic activity and prices and the basic thinking behind the Bank of Japan's conduct of monetary policy. The current situation and the outlook for economic activity and prices The Japanese economy has recently emerged from a pause that started during the summer of 2004 and continues to recover. The current economic expansion has lasted three years and eight months as of this September, based on the Cabinet Office's reference dates of business cycles, thus recording the third longest expansion phase in the post-World War II period. The economy is expected to continue to recover, albeit at a moderate pace. Real GDP growth has been strong so far this year with a large annualized increase from the previous quarter of 5.8 percent in January-March 2005, followed by a 3.3 percent increase in the April-June quarter, although it either remained unchanged or dipped slightly over the three quarters from April-June 2004. This favorable performance can be attributed to the stronger-than-expected domestic private demand, such as business fixed investment and private consumption, along with moderate export growth due to the expansion in overseas economies. In this environment, positive effects stemming from the increased corporate profits have gradually spread to household income, feeding back to the corporate sector via the increase in private consumption: in other words, there is a positive interaction between the corporate and household sectors. Industrial production is on the increase with the completion of adjustment in IT-related sectors. Overall, the current economic recovery appears moderate in pace, but sustainable. The economy is thus unlikely to fall into recession due to domestic factors. In the corporate sector, profitability has substantially improved, as the adjustment in excess capacity and employment has finally come to an end. According to Financial Statements Statistics of Corporations by Industry, current profits of Japanese firms have increased for three consecutive years from fiscal 2002, with both profits and the ratio of current profits to sales for fiscal 2004 exceeding those during the height of the bubble era. In fiscal 2005, profits are forecast to grow for the fourth consecutive year, signifying buoyancy in corporate performance. Backed by high corporate profitability, business fixed investment is growing steadily in a wide range of industries. Still, given the historically high levels of profits and cash flow, the current level of business fixed investment appears too modest. This cautious corporate behavior contributes to the mild and long-lasting recovery. However, as the economy continues to recover and the business outlook becomes brighter, an increasing number of firms are likely to start earmarking more cash flow for business fixed investment, the wellspring of their future profits, with their focus on maximizing corporate value. We will examine the robustness of business conditions, by using, for example, the results of the September Tankan (Short-Term Economic Survey of Enterprises in Japan), which will be released in early October. 1/4 Now turning to the household sector, the employment and income situations appear to be improving steadily after a prolonged period of difficulty, as a result of firms' efforts to reduce excesses in the workforce and personnel expenses. The number of employees has been increasing since last year. More recently, the number of full-time employees has begun to increase, while the rise in the number of part-time employees, who were more in demand when corporate restructuring was in full swing, has slowed. Regular payments are steadily increasing and bonus payments for this summer have also increased. Given such improvement in the employment and income situations, private consumption has been firm, and is on an upward trend, albeit with some fluctuations. Although sales of automobiles and sales at department stores were slightly weak in July and August, this was mainly in reaction to the substantial increase in sales during the April-June quarter, and the upward trend in private consumption remains intact. Of course, risk factors do exist and ought to be taken into account in assessing an economic outlook. We should pay attention to the protracted surge in crude oil prices and its possible effect on overseas economies, including that of the United States. Crude oil prices, which have been rising for the past few years, marked a record high around the end of August. Rises in crude oil prices entail the risk of deceleration of world economic growth as a result of declines in the real purchasing power of non-oil producing countries. So far, however, the world economy continues to expand at a robust pace and shows no sign of this risk materializing. There are several reasons for this. First, the recent rises in crude oil prices have not been caused by oil production capacity constraints. Rather, they are to a large extent attributable to an expansion of demand mainly in emerging countries, whose economies have enjoyed rapid growth. Second, rises in oil prices tend to cause income transfer to oil-producing countries through deterioration in the terms of trade of non-oil producing countries, thereby boosting the purchasing power of the former. The critical point in this regard is how the increased income is spent. Judging from the recent rise in Japanese exports to oil-producing countries and other evidence, it seems that a mechanism of income reflow from oil-producing countries to non-oil producing countries is in fact operating. In addition, it should be stressed that the recent crude oil hike has not led to a rise in a broad range of categories in consumer prices nor a heightening of inflationary expectations in major countries, and as a result, there has been no need for a rapid tightening of monetary policy. This can be explained by factors such as the increased credibility of monetary policy in countries pursuing price stability, and also the expansion of supply of low-priced products flowing into the global market as a result of entry of emerging countries. Long-term interest rates remain at low levels in major economies as a result of stable prices and accommodative monetary policy. The pervasive low interest rate environment has laid the foundation of world economic growth, as seen, for example, in the U.S. economy, where low mortgage interest rates have boosted housing prices and this in turn has been supporting an increase in household expenditure. If crude oil prices remain high, we should keep close watch for any sign of a rise in inflation expectations or rapid tightening of monetary policy, leading to deceleration in world economic growth. In this context, we should also assess the negative effects of the hurricane which hit the United States late last month and has caused devastating damage to the oil production facilities and refineries in the area. Based on the above economic outlook, I will elaborate on price developments. The corporate goods price index continues to rise, mainly reflecting the rise in crude oil prices, and this uptrend is expected to continue for the time being. With regard to the consumer price index (CPI), the change in the core CPI, which excludes fresh food, is hovering slightly below zero percent on a year-on-year basis. It is likely to become zero or slightly higher toward the end of the year since the negative contribution of rice prices and the reduction in electricity and telephone charges is expected to dissipate. The year-on-year rate of change in the CPI is expected to increase thereafter, as the 2/4 Japanese economy is likely to continue growing at above its potential rate, causing the gap between supply and demand to shrink further, and also the recent uptrend in wages is likely to exert upward pressures on prices. The bank's conduct of monetary policy Based on the above assessment of economic activity and prices, I will explain the Bank's thinking on the conduct of monetary policy. The Bank has been implementing the quantitative easing policy to achieve sustainable economic growth under price stability. The framework consists of two key elements. First, the Bank provides ample liquidity to the money market far in excess of required reserves. Second, the Bank is firmly committed to maintaining such ample provision of liquidity until the year-on-year rate of change in the core CPI registers zero percent or higher on a sustainable basis. This framework underpins expectations, based on inflation projections among market participants, that the quantitative easing policy will continue for some time. As a result, market interest rates remain steady at low levels, including those with relatively longer maturities. With regard to the first element, the Bank's provision of ample liquidity greatly contributed to maintaining financial system stability and an accommodative corporate financing environment by responding to precautionary demand for liquidity of financial institutions when there were strong concerns about financial system stability. Since then, concerns about financial system stability have largely subsided, as evidenced by the smooth implementation of the full removal of blanket deposit insurance in April 2005. As a result, the quantitative easing policy is effectively becoming closer to a maintenance of zero interest rates. In the current situation, the quantitative easing policy contributes to maintaining an accommodative financial environment by stabilizing market interest rates, thus allowing firms to continue to enjoy low funding costs. As for the conduct of monetary policy, the Bank will continue to maintain the quantitative easing policy based on the commitment mentioned earlier since the core CPI is still registering a slight year-on-year decline. The Bank formulated this commitment when it introduced the quantitative easing policy in March 2001. At the time, following the bursting of the global IT bubble, and the resultant sharp fall in aggregate demand, the economy had fallen into recession and prices were declining. The Bank decided to employ an unprecedented measure, linking its commitment in terms of policy duration to the observed CPI, to create further monetary easing effects even under zero interest rate conditions. Thereafter in October 2003, the Bank clarified its commitment to maintaining the quantitative easing policy. Specifically, the Bank specified two conditions. First, the year-on-year rate of increase in the core CPI must register zero percent or above over a few months. Second, the prospective year-on-year rate of increase in the CPI must not be zero percent or below. These two conditions, as necessary conditions for terminating the policy, constitute a firm commitment: in other words, the Bank commits itself to continuing the policy until they are fulfilled. At the same time, the Bank made it clear that these two conditions are not sufficient conditions in the sense that the Bank will not necessarily make an automatic decision to terminate the policy as soon as they are fulfilled. To put it in a nutshell, the Bank will decide whether to terminate the policy by examining developments in economic activity and prices and judging whether the situation justifies asserting that the year-on-year rate of change in the CPI is registering zero percent or higher on a sustainable basis--in other words, whether the commitment has effectively been fulfilled as a whole. Of course, the timing of terminating the quantitative easing policy crucially depends on developments in economic activity and prices. Based on the projections regarding economic 3/4 activity and prices mentioned earlier, the probability of terminating the policy is likely to gradually increase over the course of fiscal 2006. At that juncture, the Bank will shift the operating target for money market operations back to short-term interest rates from the outstanding balance of current accounts at the Bank. Since, as I pointed out earlier, the quantitative easing policy is effectively becoming closer to a maintenance of zero interest rates, a change in the policy framework itself does not imply an abrupt change in monetary policy. Although the future course of monetary policy obviously depends on developments in economic activity and prices, an accommodative financial environment is likely to be maintained, as long as upward pressures on prices continue to be to a large extent contained and the economy follows a sustainable and balanced growth path, as projected in the April 2005 Outlook for Economic Activity and Prices. Conclusion The Japanese economy has emerged from a pause and continues to recover, albeit at a moderate pace. The Bank is determined to carry out monetary policy so as to support private-sector initiatives, and thereby realize sustainable economic growth and stable prices. 4/4
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Remarks by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, at Emerging Opportunities in the Global Economy, the 29th Annual Joint Meeting of the Japan-US Southeast Association and Southeast US-Japan Association, Tokyo, 17 October 2005.
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Toshiro Muto: Dynamism and diversity of Asia – a central banker's view Remarks by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, at "Emerging Opportunities in the Global Economy" the 29th Annual Joint Meeting of the Japan-US Southeast Association and Southeast US-Japan Association, Tokyo, 17 October 2005. * I. * * Introduction Good morning, ladies and gentlemen. It is a great pleasure to join you at this special gathering. Asia is undergoing tremendous changes. Links between the countries in this region are getting closer. Two big countries, China and India, are growing on a global platform. These changes are taking place not only in economic terms but also in the political and diplomatic arenas. Against this background, changes in Asian dynamics are beginning to reshape the contours of the US-Asia relationship. With these things in mind, I will address four facets of today's Asia: booming economies, rising regional cooperation, looming challenges, and evolving relations with the US. II. Booming economy Following the economic crisis in 1997-98, the economies in south-east Asia have made a strong recovery. Indeed, countries in this region have exhibited impressive resilience in restoring their economic vitality. When the world economy slowed in the wake of the bursting of the IT bubble in 2002-03, Asia's solid growth helped avert the global recession. China's economic expansion is particularly remarkable as it has sustained an average growth of 8-9 percent per annum for the past decade. If you take a closer look at the current economic dynamism in Asia, you will not fail to see a stark difference from the past economic booms. In the past, trade in this area was simple. Industrial countries like Japan and Korea imported raw materials from their Asian neighbors to export final products to the US and Europe. In contrast, trade patterns within Asia are now much richer on the basis of the sophisticated vertical division of production processes. Countries are specializing in the optimal parts of the supply chain on the basis of their resource endowment and comparative advantage. This process is being propelled by foreign direct investment (FDI) coming from both within and outside the region. For example, Japan exports intermediate and capital goods to China and other Asian countries, and these countries assemble what they import from Japan in order to make final products for the global markets. Consequently, the proportion of intra-regional trade in Asia has climbed to 54 percent, which lies between NAFTA's 46 percent and the EU's 62 percent. Asia's export-led growth has increased its absorption, thereby stimulating its imports from abroad. This is particularly true of China where huge domestic demand has yet to be saturated. Because of its large population, China presents itself as both an international production hub and a big consumer market. For instance, China accounted for 7 percent of global trade in 2004. Combined with Hong Kong and Taiwan, it captures 11 percent, only slightly below the US. Against this background, China is exerting a strong influence on the global economy. Also note India, which is becoming the major off-shoring destination for foreign multinationals, particularly in the service sector. This strong performance of Asian economies might possibly be affected by the recent spike in oil prices. In fact, some Asian currencies, like the Indonesian rupiah, came under pressure when oil prices reached a record high this August. However, the economic fundamentals of most Asian countries are much stronger than in the 1970s when they were hit by the worst oil market turmoil ever. In addition, Asian countries responded swiftly this time by raising interest rates or slashing public fuel subsidies. These prompt actions have helped them minimize potential disruptions to their economies. Furthermore, Asian countries have large volumes of foreign reserves and only a small amount of external debt in comparison to both their own past and developing countries in other parts of the globe. For mutual liquidity assistance in times of external stress, countries in this region are working toward an expanded network of bilateral swap arrangements, to which I will come back in a few minutes. In short, Asian economies are better equipped with both the will and capability to fend off sources of disturbance to their sound economic growth. 1/4 III. Rising regional cooperation Under these circumstances, we have seen increasing drive for regional cooperation in Asia, especially among the "ASEAN+3 nations" consisting of the ten ASEAN countries plus Japan, China, and Korea. As I said earlier, these countries are strengthening their trade links. But similar attempts are being made in other fields as well where progress has been less impressive, such as finance, environment, energy, and scientific technology. Collaboration in these areas is proceeding in a functional and pragmatic manner. Closer trade links in Asia, as symbolized by the web of free trade agreements (FTA), are likely to promote trade liberalization and catalyze FDI flows in and out of the region, thereby providing a boost to economic globalization. In other words, regional trade arrangements are not aimed at creating an exclusionary economic bloc. To the contrary, such trade networks can make the Asian economies more open and prosperous. On the financial front, cooperation among Asian countries is gathering pace. Its prime motivation is to avert a financial crisis like the one we went through in 1997-98. Efforts in this field are producing tangible results around two pillars: 1) the establishment of bilateral swap arrangements, and 2) the development of regional bond markets. As some of you might know, there is a collegial group of central banks in this region. This group, called EMEAP, an acronym for the Executive Meeting of East Asia Pacific Central Banks, has eleven members. From its inception in 1991, EMEAP comprises nine east-Asian central banks plus two central banks from Australia and New Zealand. EMEAP is very active in three key areas, namely, financial markets, banking supervision, and settlement/payment systems. To give you a picture of what EMEAP is doing for bond market development, allow me to digress a little bit. EMEAP has engaged itself in the project known as ABF, or Asian Bond Fund. In this fund, eleven EMEAP central banks jointly set up their foreign reserves to place investment funds composed of Asian sovereign bonds. The purpose of ABF is to stimulate turnovers in the bond market in this region. In June 2003, the central banks launched ABF1, the first stage of the ABF project, to invest in dollardenominated sovereign bonds issued by Asian countries. In May 2005, EMEAP went a step further by announcing the start of ABF2. ABF2 invests in sovereign bonds issued in Asian local currencies. Although led by the EMEAP central banks, ABF is not an "Asia-only" project. Actually, Western financial services companies take part in this project as a fund manager and custodian. From what I have said, you can sense the pragmatic spirit of Asian regional cooperation. In fact, pragmatism is the hallmark of joint initiatives in this region. Another point is that these cooperative endeavors are largely market-driven. Put differently, Asian cooperation is an "autonomous" process. It is in sharp contrast to the EU integration where member nations have agreed to transfer some of their sovereignty to Brussels, Frankfurt, and other European cities to operate supra-national governance. Therefore, Asian regional collaboration does not have a lead player a priori. Instead, a variety of players are involved. In fact, Asia has several groups of different stripes, like EMEAP, ASEAN, ASEAN+3, Asian Development Bank (ADB), each with its own unique membership. Such an "open-ended" modality for regional cooperation reflects Asia's diversity in ethnic, historical, religious, and linguistic backgrounds. Some say that Asia's diversity could weaken its regional unity. There is some truth in this view, but diversity has its own advantages as well. It can create an environment in which people appreciate different values and ideas, develop a sense of tolerance to others, and become more innovative through such cross-cultural interaction. This is a unique advantage for Asia to maximize, and I believe Asian cooperation should move ahead in this direction. The first East Asian Summit meeting is slated for this December. The summit will be attended by the leaders of ASEAN+3 nations, India, Australia, and New Zealand and will be the first of its kind. This gathering of countries attests to the flexibility of Asia's cooperation. Given the prospect for energy development in east Siberia or Sakhalin, the attendees to the East Asian Summit may even include Russia in the future. But this is anyone's guess, of course. IV. Looming challenges Despite the collective progress so far made, Asian countries are facing new challenges. In my judgment, response to these problems will define the path of Asian cooperation going forward. There is no doubt that high growth has enabled Asia to savor better economic welfare. However, I see four challenges to further prosperity in Asia; 2/4 • accelerate financial market integration • establish sound socioeconomic infrastructures like intellectual property right protection, transparent corporate governance, and impartial judiciary • tackle transnational problems like regional epidemics, natural calamities and environmental disruptions • formulate sustainable energy policy First, financial market integration. Financial markets in Asia are still ring-fenced by national borders. That makes it hard to link savings with investment opportunities within the region efficiently. As I said, the financial authorities in Asia are working together to develop liquid bond markets, as they expect such markets to facilitate the marriage of savings and investment in the region. Organic linkage of savings and investment would underpin sustainable growth in Asia, thereby contributing eventually to the adjustment of global payment imbalances. Second, socioeconomic infrastructures. In a nutshell, Asia has yet to establish its credentials as an economic area where the rule of law receives due respect. This is particularly crucial since Asia derives enormous benefits from FDI flows via foreign multinationals. In order to sustain FDI inflows, it is of vital importance to provide legal protection of patents, brands, and copyrights. Asia also needs to consolidate a law-abiding and corruption-free business culture to help legal frameworks function effectively. Third, transnational problems. These problems have global dimensions, but they have some Asian features as well. The nightmare of the tsunami disaster is still vivid in our memory, but this region has other weather-related anomalies, including tropical cyclones, floods, droughts, and dust storms, some of which are exacerbated by desertification and deforestation. It is easy to see how these natural disasters decimate our economies. In addition, given the high population density and still-poor sanitation infrastructures in Asia, systematic steps should be taken to contain the spread of lethal epidemics such as avian flu, HIV/AIDS and SARS before they become a global pandemic. The spread of these contagious diseases will virtually halt the cross-border movement of goods and people, thereby causing fatal damage to our economies. Both natural disasters and public health crises call for rapid intervention by the relevant authorities. In order to formulate effective emergency response, we may as well study swiftly a possible region-wide mechanism for surveillance, early warning, and information sharing. Concerted efforts by countries in this region would also make it easier to obtain badly needed international funding for the prevention and mitigation of such human emergencies. Fourth, energy policy. Asian emerging countries are big consumers of energy, while they have little natural resources to count on. This means that, to sustain the present economic rise, these countries need to secure stable sources of energy while developing alternative energy supplies as well. Equally important is a demand-side effort to curtail energy intensity. Better energy efficiency is also helpful in reducing air pollution and green house gas emission. I said earlier that Asian regional cooperation should proceed without rigid boundaries regarding membership. As geography is relative, boundaries should be "open-ended." As far as financial markets are concerned, however, membership can be defined by the time zone. The majority of East Asian countries are located within the 3-hour time band from Sydney to Bangkok. Thus, it is of little surprise that the countries in this zone constitute the core of numerous regional groups. But it will be too naive to assume that Asia alone can handle all the challenges I have described. For instance, we should learn more from the US and Europe when it comes to transparent governance, biomedical technology, public hygiene, and environmental conservation. Being "open-ended" will continue to be an essential element for Asian cooperation. V. Evolving relations with the US Now let me conclude by adding a few words on US-Asia relations. The trans-pacific economic space, spanning Asia and the US continent, explains roughly half the global GDP. In regard to cross-border money flows, the vast portion of Asia's savings are invested in US financial markets, and then recycled back to Asia in the form of FDI by multinationals. The ongoing RMB (renminbi) reform could lead to a substantial change in the monetary landscape between Asia 3/4 and the US. Given these and other elements I do not cover today, Asia and the US will most likely continue to assume shared responsibility for the smooth functioning of the global economic architecture. Besides the economic issues, Asia's cohesion is as evident as that of Europe. Unlike Europe, however, Asian countries are divided or "linked," I would say, by the sea. Therefore, the safety and stability of sea routes are vital for the cross-border movement of goods, services, and people. With respect to culture, ethnicity, and religion, Asia remains an area of immense diversity. Also, Asia is undergoing profound changes as I said at the outset. Dynamic and diversified perspectives, instead of linear and stereotyped views, help us understand what is going on in Asia, upon which productive US-Asia relations develop. As the US-Asia relationship evolves into a multi-layered nexus like a tapestry, it is essential for leaders on both sides of the Pacific to interact closely through prominent forums like the one we are attending today. Let us hope that our trans-pacific ties will continue to be solid on this basis. Thank you for your attention. 4/4
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Summary of a speech given by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the Kisaragi-kai meeting, Tokyo, 11 November 2005.
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Toshihiko Fukui: Towards a new path of growth for the Japanese economy Summary of a speech given by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the Kisaragi-kai meeting, Tokyo, 11 November 2005. * * * Introduction Semiannually in April and October, the Policy Board of the Bank of Japan decides the text of the Outlook for Economic Activity and Prices, or the Outlook Report as we call it, and releases it. This report describes the Bank's outlook for economic activity and prices which provides the basis for conducting monetary policy, and also explains the Bank's thinking behind its conduct of monetary policy. Today I would like to focus on the October 2005 Outlook Report, which was published two weeks ago. I. Recent economic developments and the outlook for economic activity Japan's economy continues to recover, having emerged from the temporary pause that began in the summer of 2004. The adjustments in production and inventory in IT-related sectors, which triggered the temporary pause, appear to have run their course, and domestic private demand, such as business fixed investment and private consumption, has been stronger than expected. According to the Cabinet Office's reference dates of business cycles, the economy has been expanding since the beginning of 2002, that is to say, for almost four years now. Although a V-shaped recovery is unlikely to ensue after the economy's recent emergence from its temporary pause, it is expected to achieve solid growth at a moderate and sustainable pace. The Bank's projection for a period of one and a half years ahead, that is, through the end of fiscal 2006, is that the economy is likely to experience a sustained period of expansion at a pace slightly above its potential. The Bank's main purpose in releasing the Outlook Report is to explain its thinking on the underlying mechanisms of economic activity and prices, and the Policy Board members' forecasts are also provided as reference figures. In the October Outlook Report, the Policy Board members forecast a real GDP growth rate for fiscal 2005 of slightly above 2.0 percent and for fiscal 2006 of around 1.52.0 percent. If the economy performs as projected in the October Outlook Report, it will have been expanding at a pace above its potential for a very long period of time, since the actual growth rates for fiscal 2003 and 2004 have been around 2.0 percent, exceeding the Bank's estimate of a potential growth rate of around 1.0 percent. This outlook for economic growth rests on the following underlying mechanisms. Exports are likely to remain on the increase reflecting the continuing expansion of overseas economies, and against this background, the corporate sector is likely to continue to show strength, and the positive effects of strong corporate performance will steadily exert an influence on the household sector-in other words, economic growth will be led by domestic and external demand that are well in balance. Furthermore, the extremely accommodative financial conditions are likely to support private demand. What is notable is that domestic private demand, especially business fixed investment and private consumption, is likely to remain strong. The context behind this is that the adjustment pressures in the corporate sector and the financial system that have been hindering the Japanese economy from achieving a sustainable growth path since the bursting of the economic bubble have mostly dissipated. Specifically, in the corporate sector, firms have almost resolved the excess in debt, employment, and production capacity-the "three excesses." As for the financial system, the nonperforming-loan (NPL) problem, which has placed downward pressure on the economy together with these three excesses, has nearly been resolved. Diffusion indexes for production capacity and employment conditions in the September 2005 Tankan (Short Term Economic Survey of Enterprises in Japan) are at the level of 1992, immediately after the bursting of the economic bubble, showing that adjustments in the excesses have made much progress. In particular, the number of firms perceiving their holdings of labor as insufficient exceeded the number perceiving them as excessive, implying that firms are starting to see themselves as short of labor. Firms have also substantially reduced their interest-bearing liabilities, as evidenced by the marked decline in the ratios of outstanding debt to total assets and to sales not only at large firms but also small and medium-sized firms in the last few years. While making adjustments in the three excesses, firms have been reviewing their business lines based on the principle of "selection and concentration" and improving their ability to generate high-valueadded products and services as they face intensified global competition. As a result, their profitability has improved greatly. According to the Financial Statements Statistics of Corporations by Industry, current profits of Japanese firms have increased for three consecutive years from fiscal 2002, with both profits and the ratio of current profits to sales for fiscal 2004 exceeding those during the height of the bubble era. Despite the headwind of a surge in crude oil prices, corporate profits are likely to continue on an uptrend in fiscal 2005. Given the high corporate profits, business fixed investment has been increasing steadily in a wide range of industries and is also expected to continue increasing. In the Tankan survey, business fixed investment plans of large manufacturers for fiscal 2005 showed a double-digit increase for the second consecutive year, and small and medium-sized firms are also revising their plans upward. As a result, business fixed investment is expected to increase for the third consecutive year for firms of all sizes in all industries. The strength of the corporate sector is steadily spreading to the household sector. In particular, improvements in the employment and income situation are becoming noticeable. Firms have been placing priority on restraining labor costs, but their stance on employment is becoming positive with the problem of excessive holdings of labor in the corporate sector nearly resolved. One notable example suggesting a change in firms' stance on employment is that the ratio of part-time workers to regular employees, which had been generally on an uptrend since the bursting of the economic bubble, has started to decline. With respect to wages, summer bonus payments have recorded relatively high increases, and regular compensation has started to increase very slightly due partly to the peaking out of the ratio of part-time workers. Supported by the improvement in the employment and income situation, employee income is likely to continue to increase moderately, and against this background, private consumption is expected to continue to rise steadily. Although private consumption has been somewhat weak since the summer, it should be regarded as a reaction to the strong developments in the first half of 2005 and it is likely that this weakness will be temporary, given that positive influences from the corporate sector to households are spreading steadily via increases in employee income. There have also been remarkable improvements in the financial system. The NPL problem, which has long been a burden on the Japanese economy, has generally been resolved. The amount outstanding of NPLs at major and regional banks has been decreasing since reaching its peak at the end of fiscal 2001, and due mainly to the resulting decline in credit costs, their earnings for fiscal 2004 were the highest in recent years. Net income turned positive in fiscal 2004, for the first time since fiscal 2000 at major banks and since fiscal 1994 at regional banks. Against the background of improvements in profitability and capital adequacy ratios, financial institutions' lending attitude has become more accommodative. Bank lending, excluding the effects of marketing of loan assets and disposal of NPLs, has turned positive on a year-on-year basis since this August, after a prolonged decrease. Financing in capital markets through, for example, issuance of CP and corporate bonds has also been favorable for firms. In this situation, firms' perception of their financial positions has improved to the level of the early 1990s. Such accommodative financial conditions seem to be contributing to the recent increases in housing investment as well as business fixed investment by small and medium-sized firms. These accommodative financial conditions are likely to support private demand. II. Pace of recovery Japan's economy is likely to continue to expand against the background I have just explained. As I mentioned at the beginning of this speech, the pace, however, is expected to be moderate with less likelihood of acceleration. The main reason for this is the cautiousness of corporate behavior, which is expected to persist. It seems that firms have still not become confident about the future, having come through a protracted period of low economic growth following the bursting of the economic bubble. Relative to the recordhigh level of profits that firms have been posting, the improvement in business sentiment, according to, for example, the Tankan survey, is only moderate. Although business fixed investment has been increasing, it still remains substantially below the level of cash flow, and firms are reluctant to aggressively increase fixed investment by raising the funds through bank loans or capital markets. While an increasing number of firms are making more efficient use of cash flow since they have nearly completed paying back their excess debt, they still appear cautious about accelerating inventory and capital investments in response to increases in sales and production. As a result of such corporate behavior, economic recovery is likely to remain moderate but at the same time excessive build-up of stocks is unlikely. The current economic recovery, which is already the third longest in the post-World War II period, is likely to be sustained for this reason. III. Positive and negative deviations Japan's economy is expected to continue to recover supported by strength in both the corporate and household sectors with adjustment pressures that have lingered since the bursting of the economic bubble dissipating. Under these conditions, it is unlikely that the economy will fall into recession due to domestic factors, although with globalization, Japan's economy could be adversely affected in the event of a major external shock, for example, a slowdown of the global economy. It is therefore necessary to pay attention to the path of the global economy, as this could pose a downside risk to Japan's economy. In particular, developments in crude oil prices, which continue to be high, and a possible shift from the current accommodative financial conditions observed globally require close monitoring. Overseas economies, in particular the U.S. and Chinese economies, are likely to continue to expand. The International Monetary Fund (IMF) also expects a high rate of world economic growth, forecasting 4.3 percent real growth both in 2005 and 2006, even though the figure falls short of 5.1 percent, a historic high marked in 2004. Although the growth of the U.S. economy is expected to slow temporarily due to the effects of hurricanes, it is expected to basically continue to expand at a pace around its potential growth rate, partly since there is likely to be reconstruction-related demand. As for the Chinese economy, inventory adjustment has been in progress mainly in sectors related to domestic demand since the second half of 2004 in response to the government's measures to rein in the overheated economy. However, inventory adjustment pressures are likely to taper off in the face of robust economic growth. Despite the ongoing global economic expansion, there is recently increased awareness of downside risks stemming from the surge in crude oil prices. So far, the global economy has continued to expand despite the record-high level of crude oil prices. A number of factors have contributed to this development. First, one of the primary factors of the surge in crude oil prices is increased global demand, reflecting developments such as high growth in emerging economies, and there is little influence from supply-side constraints. Second, a mechanism of income reflow from oil-producing to non-oil-producing countries is operating. The third and the most important factor from central bankers' viewpoint is that the rise in crude oil prices has not led to a sharp rise in inflationary expectations, and thus monetary policy has not been tightened aggressively. This is because inflationary expectations have been contained as a result of the intensified global competition accompanying emerging economies' transition to a market economy, and central banks have been taking appropriate monetary policy measures. Long-term interest rates in the United States and other major industrial countries have not yet shown any clear upward movement compared with two years ago when crude oil prices started to rise and a year and a half ago when the Federal Reserve started to raise the federal funds rate target. The coincidence of surging oil prices and relatively low long-term interest rates in a climate of stable economic expansion is hard to explain on the basis of past experience. A growing sense of a surfeit of funds in the economy stemming from the slack in the global balance between savings and investment and the increase in investment in long-term bonds by institutional investors, such as pension funds, have been cited as factors. However, since long-term interest rates basically reflect the market's outlook for economic activity and prices, the fact that inflationary expectations have been contained has greatly contributed to the stability in the rates. The maintenance of accommodative financial conditions has played a crucial role in the global economic expansion. This is evident in the United States in particular, where stability in long-term interest rates, by causing a continued rise in housing prices, has led to buoyant spending by households through the wealth effect, and this in turn has been supporting economic expansion. Should there be unexpected changes in monetary accommodation in light of rising inflationary expectations caused by, for example, a further rise in crude oil prices, not only would growth in advanced economies slow but the global economy including emerging economies could also be adversely affected, perhaps via a shift in the international flow of funds. So much for downside risks: let us now look at upside potentials. The domestic view of the outlook for the Japanese economy tends to be pessimistic, due probably to the experience of low growth that lasted for more than a decade. The view held overseas, however, has become increasingly optimistic, with the October 8 issue of The Economist carrying a feature titled "The sun also rises." In fact, firmness in Japanese stock prices since this summer owes significantly to the active investment by foreign investors. As for the Bank's outlook, it assumes that corporate behavior will generally remain cautious. However, with the three excesses having run their course, and the marked progress in restructuring corporate balance sheets, it is probable that firms will become more confident about the economic outlook as the economic recovery continues. In that case, firms, supported by accommodative financial conditions, are likely to increase business fixed investment and hiring. Under such circumstances, if there are stronger positive influences from the corporate sector to households via increases in employee income, household spending may increase further. These developments would entail an acceleration of economic recovery. Developments in asset prices such as stock prices and land prices reflect people's perceptions about the economic outlook. Asset prices are determined based on future cash flow expected to be generated, and they therefore contain important information about people's view of the future. Recently, stock prices have been strong, and land prices in some parts of Tokyo and other major metropolitan areas have started to rise, suggesting an upturn in people's expectations regarding the economy. However, land prices on the whole continue to be on the decline. Thus, not all asset prices are increasing, reflecting continuing caution in people's perception of the outlook. Since developments in asset prices reflect changes in people's perceptions as well as influence investment activity of firms and households, they require close attention. IV. Outlook for prices Given this economic outlook, the environment influencing prices is likely to change gradually. The output gap is expected to continue narrowing moderately as the economy continues to recover. Firms' and households' expectations regarding prices play an important role in the formation of prices via, for example, firms' price setting stance. Various survey results show that the number of respondents perceiving that prices will rise in the future has been increasing gradually since hitting bottom in 2001-02. The consumer price index (CPI; excluding fresh food) has been decreasing on a year-on-year basis since the middle of 1998 for more than seven years now. Recently, however, the pace of decline has slowed considerably, with a 0.1 percent decline in September year-on-year. As the effects of special factors such as the decline in rice prices and the reduction in electricity and telephone charges fall off, the year-on-year changes in the CPI are likely to turn positive toward the end of 2005. Thereafter, in this environment, the year-on-year changes are expected to remain positive. Forecasts of the majority of Policy Board members for the CPI in fiscal 2006 are between 0.4 and 0.6 percent on a year-on-year basis. Despite the fact that the economy has been growing at a pace above its potential since fiscal 2003, over two years now, and the output gap continues to improve, the impact on prices has remained small. This is mainly because the decline in unit labor costs-labor costs per unit of production of goods and services-which was brought about by a decline in wages and a rise in productivity worked to contain upward pressure on prices. Unit labor costs are unlikely to record a clear increase in the near future because the rise in productivity will still tend to hold them down despite the increases in wages. In this situation, it is unlikely that the pace of increase in prices will accelerate. The impact of economic activity on prices has been weakening, and this has been a global phenomenon. However, it is uncertain whether this will continue in the future. A sustained narrowing of the output gap may cause a greater-than-anticipated increase in inflationary expectations. This can prompt firms to pass increases in costs, for example, a rise in input prices, on to sales prices. Although it is most likely that the rise in prices will be contained, the risk of an upward deviation in prices should nevertheless be kept in mind. V. Conduct of monetary policy It has been four and a half years since the Bank first introduced the framework of the quantitative easing policy. This policy is unprecedented not only in the history of Japan but anywhere in the world. In the spring of 2001, Japan faced an economic deterioration and a decline in prices, and concerns about financial system stability intensified. With regard to monetary policy, short-term interest rates were already practically zero percent and the Bank could not reduce them further. In response to this situation, the Bank introduced the current quantitative easing policy framework, which has two pillars: provision by the Bank of ample liquidity to the money market so that the outstanding balance of current accounts at the Bank exceeds the amount of required reserves; and a commitment by the Bank to continue with this ample provision of liquidity until the year-on-year rate of change in the CPI (excluding fresh food) registers zero percent or higher on a sustainable basis. When there were strong concerns over the stability of the financial system, the Bank's ample provision of liquidity, which met financial institutions' liquidity demand, stabilized financial markets and maintained accommodative financial conditions, and thus contributed to averting a contraction in economic activity. This was the case in 2001-02 when the disposal of NPLs at major banks reached its peak and the partial removal of blanket deposit insurance drew near, and in 2003 when public funds were injected into Resona Bank. The commitment by the Bank, together with market participants' expectations for consumer prices, has led them to expect that short-term interest rates will remain at zero percent for some time, and as a result longer-term interest rates have remained stable at low levels. The quantitative easing policy has thus been contributing greatly to the recovery in Japan's economy through the Bank's provision of ample liquidity and its policy commitment. The effects of the quantitative easing policy have been changing with developments in economic activity and prices as well as the state of the financial system since its introduction. With regard to the effects of ample liquidity provision by the Bank, an effect of reducing very short-term interest rates to practically zero percent remains unchanged. However, as described earlier, with the progress in the disposal of NPLs, precautionary demand for liquidity has declined substantially, reflecting diminishing concerns over financial system stability. The effects of the policy commitment by the Bank have also been changing. In principle, the expected duration of the quantitative easing policy based on the Bank's commitment can either lengthen or shorten depending on market participants' expectations for prices. With more market participants recently expecting that the year-on-year rate of change in the CPI will be a positive figure in the near future, the duration of the policy as expected by market participants is shortening. As a result, the policy commitment is gradually losing its influence on the formation of longer-term interest rates. This is a natural consequence considering the characteristics of the commitment. As a result of the above changes, the stimulative effects of the quantitative easing policy on economic activity and prices are at present increasingly coinciding with the effects of short-term interest rates being at practically zero percent. As for a change of policy framework, the Bank will judge whether the policy commitment has effectively been fulfilled, in other words, whether the year-on-year rate of change in the CPI is registering zero percent or higher on a sustainable basis, by monitoring economic activity and price developments. Assuming that economic activity and price developments follow the projection described in the October Outlook Report, the possibility of a departure from the present monetary policy framework is likely to increase over the course of fiscal 2006. We cannot tell exactly when the Bank will actually change the framework, since it depends on future economic and financial developments. In any case, the Bank will appropriately determine the timing in view of these developments. Such a change of framework would mean a reduction in the outstanding balance of current accounts at the Bank toward a level in line with required reserves, and a shift in the main operating target for money market operations from the outstanding balance of current accounts to short-term interest rates. At present, the effects of the quantitative easing policy are increasingly coinciding with the effects of short-term interest rates being at practically zero percent. Thus, a change of policy framework itself does not imply an abrupt change in terms of effects of policy. There will then be a period of very low short-term interest rates followed by a gradual adjustment to a level consistent with economic activity. Conceptually, the course of monetary policy after the change of framework will be a reduction in the outstanding balance of current accounts, a period of very low short-term interest rates, and a gradual adjustment to a level consistent with economic activity. How exactly the Bank will proceed, in other words, how the Bank will reduce the outstanding balance of current accounts and set the level and time path of short-term interest rates thereafter, will depend on future developments in economic activity and prices as well as financial conditions. In this regard, if it is judged that upward pressure on prices continues to be contained and the economy follows a sustainable and balanced growth path, this is likely to give the Bank latitude in conducting monetary policy through the entire process. Based on this, I would like to point out two things. First, when reducing the outstanding balance of current accounts, the Bank will need to monitor financial market conditions carefully. With the Bank's quantitative easing policy, financial institutions have for a long period of time been conducting their financing based on the existence of the large current account balance at the Bank. Although the functioning of the money market will recover eventually, investment and raising of funds in financial markets may be hindered for a while after the change of framework. And second, it is essential to ensure that financial markets are able to perform the pricing function smoothly, reflecting underlying economic and price conditions. The markets in principle perform the function of envisaging future monetary policy based on economic and price conditions and also perform the function of forming interest rates. However, given that there is no precedent for a change from the current policy framework to another, it is important for the purpose of smooth formation of interest rates that the Bank clearly explain its assessment of economic activity and prices as well as the thinking behind the conduct of monetary policy, and endeavor to stabilize market expectations. In order to realize sustainable economic growth and stable prices, the Bank will take measures in an appropriate and timely manner in response to economic and financial developments. Conclusion I have talked mainly about the content of the October Outlook Report as well as expected developments in Japan's economy and the thinking behind the conduct of monetary policy. The economy is on the threshold of a new path of growth, after an adjustment process lasting over ten years since the bursting of the economic bubble. The Bank will continue to conduct monetary policy appropriately and support this growth from the financial side.
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Statement by Mr Toshihiko Fukui, Governor of the Bank of Japan, concerning the Bank's Semiannual Report on Currency and Monetary Control, before the Committee on Financial Affairs, House of Councillors, Tokyo, 18 October 2005.
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Toshihiko Fukui: Semiannual report on currency and monetary control Statement by Mr Toshihiko Fukui, Governor of the Bank of Japan, concerning the Bank's Semiannual Report on Currency and Monetary Control, before the Committee on Financial Affairs, House of Councillors, Tokyo, 18 October 2005. * * * Introduction The Bank of Japan submitted its Semiannual Report on Currency and Monetary Control for the second half of fiscal 2004 to the Diet in June 2005. I am pleased to have this opportunity to present an overall review of the Bank's conduct of monetary policy. I. Developments in Japan's economy Japan's economy has emerged from its temporary pause that started during the summer of 2004, and continues to recover. Exports are continuing to increase moderately against the background of the expansion of overseas economies, although the momentum of export growth, especially to China, weakened temporarily. Production is on an uptrend with some fluctuations, partly due to the completion of inventory adjustment in IT-related sectors. Business fixed investment is growing steadily in a wide range of industries, as corporate profits remain high and business sentiment has been showing a gradual improvement. As for the household sector, after a prolonged period of difficulty due to firms' efforts to reduce excess labor and personnel expenses, household income has been rising moderately, as the number of employees has been increasing and wages have picked up. With this improvement in the employment and income situation, private consumption has been steady. Looking forward, exports are expected to continue rising against the background of the expansion of overseas economies. Domestic private demand is likely to continue increasing against the backdrop of high corporate profits and the moderate rise in household income, as structural adjustment pressure stemming from firms' excess capacity and labor has almost dissipated. Given this situation, the economy is likely to experience a relatively long period of growth, albeit at a moderate pace. Nevertheless, there are risk factors such as the continuing surge in crude oil prices and its possible effect on overseas economies, and these should be monitored closely. On the price front, domestic corporate goods prices have been increasing mainly reflecting the effects of high crude oil prices, and this uptrend is expected to continue. Consumer prices (excluding fresh food, on a nationwide basis) have been declining slightly on a year-on-year basis partly due to the reduction in electricity and telephone charges against the background of such factors as deregulation. The year-on-year rate of change in consumer prices is projected to be zero percent or a slight increase toward the end of the year, as the effects of temporary factors, such as the decline in rice prices and the reduction in electricity and telephone charges, fall off. The year-on-year rate of change in the consumer price index (CPI) is expected to increase thereafter, as the Japanese economy is likely to continue growing at above its potential rate, causing the gap between supply and demand to shrink further. On the financial front, the environment for corporate finance is becoming more accommodative on the whole. The lending attitude of financial institutions has been becoming more active. Under these circumstances, the negative year-on-year change in the amount of lending by private banks observed since 1998 has gradually improved, and the amount of their lending is currently at around the previous year's level. The environment in the capital markets for firms raising funds through CP and corporate bonds continues to be favorable. II. Conduct of monetary policy The Bank has been providing ample liquidity based on the quantitative easing policy. At the Monetary Policy Meeting (MPM) on October 11 and 12, 2005, the Policy Board decided to maintain the target range for the outstanding balance of current accounts held at the Bank at "around 30 to 35 trillion yen." The framework of the quantitative easing policy is based on two key elements. The first element is the Bank's provision of ample liquidity to the money market so that the outstanding balance of current accounts at the Bank substantially exceeds the amount of required reserves. The second is the Bank's commitment to firmly maintain this ample provision of liquidity until the year-on-year rate of change in the CPI registers zero percent or higher on a sustainable basis. Regarding the first element, the Bank's provision of ample liquidity contributed greatly to maintaining financial system stability and an accommodative corporate financing environment by responding to financial institutions' precautionary demand for liquidity when there were strong concerns about financial system stability. Since then, such concerns have largely subsided, as evidenced by the smooth implementation of the full removal of blanket deposit insurance in April 2005. As a result, financial institutions' precautionary demand for liquidity has been on a declining trend. Under these circumstances, since the MPM held on May 19 and 20, 2005, the Bank has been allowing the outstanding balance to temporarily fall below the target range when it is judged, in a situation where the Bank is doing its utmost to provide funds while at the same time giving due consideration to the effects on the functioning of the market, that financial institutions' liquidity demand is exceptionally weak. This decision is intended to enable the quantitative easing policy to be conducted more smoothly by making it possible for liquidity to be provided with a minimum of hindrance to the process of price formation and efficient allocation of funds in the financial markets. In the current situation, the quantitative easing policy contributes to maintaining an accommodative financial environment by stabilizing market interest rates, thus allowing firms to continue to enjoy low funding costs. The commitment's positive effects through interest rates on the economy are strengthening as corporate profits increase with economic recovery. Conclusion Japan's economy has emerged from its temporary pause and continues to recover. As for the outlook, it is likely to experience a relatively long period of growth, albeit at a moderate pace, and the Bank will continue its close monitoring of developments. At the meeting of general managers of the Bank's branches scheduled for October 20, the Bank will examine the state of the economy in each region thoroughly based on the report presented there. The Bank will continue to conduct monetary policy appropriately based on careful examination of developments in economic activity and prices. In the current situation where the CPI has been declining slightly on a year-on-year basis, the Bank is determined to support Japan's economy from the financial side to achieve sustainable economic growth with price stability, by maintaining monetary easing in accordance with the commitment based on the CPI. The Bank will also continue to pursue more advanced central bank services as well as ensure welldisciplined management, according to a Medium-Term Strategic Framework for fiscal 2005-2009 formulated in March 2005, in order to properly carry out the duties entrusted to it as the nation's central bank.
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Remarks by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, at 'Emerging Opportunities in the Global Economy' the 29th Annual Joint Meeting of Japan-U.S. Southeast Association and Southeast U.S.-Japan Association, Tokyo, 17 October 2005.
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Toshiro Muto: Dynamism and diversity of Asia - a central banker's view Remarks by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, at "Emerging Opportunities in the Global Economy" the 29th Annual Joint Meeting of Japan-U.S. Southeast Association and Southeast U.S.-Japan Association, Tokyo, 17 October 2005. * I. * * Introduction Good morning, ladies and gentlemen. It is a great pleasure to join you at this special gathering. Asia is undergoing tremendous changes. Links between the countries in this region are getting closer. Two big countries, China and India, are growing on a global platform. These changes are taking place not only in economic terms but also in the political and diplomatic arenas. Against this background, changes in Asian dynamics are beginning to reshape the contours of the US-Asia relationship. With these things in mind, I will address four facets of today's Asia: booming economies, rising regional cooperation, looming challenges, and evolving relations with the US. II. Booming economy Following the economic crisis in 1997-98, the economies in south-east Asia have made a strong recovery. Indeed, countries in this region have exhibited impressive resilience in restoring their economic vitality. When the world economy slowed in the wake of the bursting of the IT bubble in 2002-03, Asia's solid growth helped avert the global recession. China's economic expansion is particularly remarkable as it has sustained an average growth of 8-9 percent per annum for the past decade. If you take a closer look at the current economic dynamism in Asia, you will not fail to see a stark difference from the past economic booms. In the past, trade in this area was simple. Industrial countries like Japan and Korea imported raw materials from their Asian neighbors to export final products to the US and Europe. In contrast, trade patterns within Asia are now much richer on the basis of the sophisticated vertical division of production processes. Countries are specializing in the optimal parts of the supply chain on the basis of their resource endowment and comparative advantage. This process is being propelled by foreign direct investment (FDI) coming from both within and outside the region. For example, Japan exports intermediate and capital goods to China and other Asian countries, and these countries assemble what they import from Japan in order to make final products for the global markets. Consequently, the proportion of intra-regional trade in Asia has climbed to 54 percent, which lies between NAFTA's 46 percent and the EU's 62 percent. Asia's export-led growth has increased its absorption, thereby stimulating its imports from abroad. This is particularly true of China where huge domestic demand has yet to be saturated. Because of its large population, China presents itself as both an international production hub and a big consumer market. For instance, China accounted for 7 percent of global trade in 2004. Combined with Hong Kong and Taiwan, it captures 11 percent, only slightly below the US. Against this background, China is exerting a strong influence on the global economy. Also note India, which is becoming the major off-shoring destination for foreign multinationals, particularly in the service sector. This strong performance of Asian economies might possibly be affected by the recent spike in oil prices. In fact, some Asian currencies, like the Indonesian rupiah, came under pressure when oil prices reached a record high this August. However, the economic fundamentals of most Asian countries are much stronger than in the 1970s when they were hit by the worst oil market turmoil ever. In addition, Asian countries responded swiftly this time by raising interest rates or slashing public fuel subsidies. These prompt actions have helped them minimize potential disruptions to their economies. Furthermore, Asian countries have large volumes of foreign reserves and only a small amount of external debt in comparison to both their own past and developing countries in other parts of the globe. For mutual liquidity assistance in times of external stress, countries in this region are working toward an expanded network of bilateral swap arrangements, to which I will come back in a few minutes. In short, Asian economies are better equipped with both the will and capability to fend off sources of disturbance to their sound economic growth. III. Rising regional cooperation Under these circumstances, we have seen increasing drive for regional cooperation in Asia, especially among the "ASEAN+3 nations" consisting of the ten ASEAN countries plus Japan, China, and Korea. As I said earlier, these countries are strengthening their trade links. But similar attempts are being made in other fields as well where progress has been less impressive, such as finance, environment, energy, and scientific technology. Collaboration in these areas is proceeding in a functional and pragmatic manner. Closer trade links in Asia, as symbolized by the web of free trade agreements (FTA), are likely to promote trade liberalization and catalyze FDI flows in and out of the region, thereby providing a boost to economic globalization. In other words, regional trade arrangements are not aimed at creating an exclusionary economic bloc. To the contrary, such trade networks can make the Asian economies more open and prosperous. On the financial front, cooperation among Asian countries is gathering pace. Its prime motivation is to avert a financial crisis like the one we went through in 1997-98. Efforts in this field are producing tangible results around two pillars: 1) the establishment of bilateral swap arrangements, and 2) the development of regional bond markets. As some of you might know, there is a collegial group of central banks in this region. This group, called EMEAP, an acronym for the Executive Meeting of East Asia Pacific Central Banks, has eleven members. From its inception in 1991, EMEAP comprises nine east-Asian central banks plus two central banks from Australia and New Zealand. EMEAP is very active in three key areas, namely, financial markets, banking supervision, and settlement/payment systems. To give you a picture of what EMEAP is doing for bond market development, allow me to digress a little bit. EMEAP has engaged itself in the project known as ABF, or Asian Bond Fund. In this fund, eleven EMEAP central banks jointly set up their foreign reserves to place investment funds composed of Asian sovereign bonds. The purpose of ABF is to stimulate turnovers in the bond market in this region. In June 2003, the central banks launched ABF1, the first stage of the ABF project, to invest in dollardenominated sovereign bonds issued by Asian countries. In May 2005, EMEAP went a step further by announcing the start of ABF2. ABF2 invests in sovereign bonds issued in Asian local currencies. Although led by the EMEAP central banks, ABF is not an "Asia-only" project. Actually, Western financial services companies take part in this project as a fund manager and custodian. From what I have said, you can sense the pragmatic spirit of Asian regional cooperation. In fact, pragmatism is the hallmark of joint initiatives in this region. Another point is that these cooperative endeavors are largely market-driven. Put differently, Asian cooperation is an "autonomous" process. It is in sharp contrast to the EU integration where member nations have agreed to transfer some of their sovereignty to Brussels, Frankfurt, and other European cities to operate supra-national governance. Therefore, Asian regional collaboration does not have a lead player a priori. Instead, a variety of players are involved. In fact, Asia has several groups of different stripes, like EMEAP, ASEAN, ASEAN+3, Asian Development Bank (ADB), each with its own unique membership. Such an "open-ended" modality for regional cooperation reflects Asia's diversity in ethnic, historical, religious, and linguistic backgrounds. Some say that Asia's diversity could weaken its regional unity. There is some truth in this view, but diversity has its own advantages as well. It can create an environment in which people appreciate different values and ideas, develop a sense of tolerance to others, and become more innovative through such cross-cultural interaction. This is a unique advantage for Asia to maximize, and I believe Asian cooperation should move ahead in this direction. The first East Asian Summit meeting is slated for this December. The summit will be attended by the leaders of ASEAN+3 nations, India, Australia, and New Zealand and will be the first of its kind. This gathering of countries attests to the flexibility of Asia's cooperation. Given the prospect for energy development in east Siberia or Sakhalin, the attendees to the East Asian Summit may even include Russia in the future. But this is anyone's guess, of course. IV. Looming challenges Despite the collective progress so far made, Asian countries are facing new challenges. In my judgment, response to these problems will define the path of Asian cooperation going forward. There is no doubt that high growth has enabled Asia to savor better economic welfare. However, I see four challenges to further prosperity in Asia; • accelerate financial market integration • establish sound socioeconomic infrastructures like intellectual property right protection, transparent corporate governance, and impartial judiciary • tackle transnational problems like regional epidemics, natural calamities and environmental disruptions • formulate sustainable energy policy First, financial market integration. Financial markets in Asia are still ring-fenced by national borders. That makes it hard to link savings with investment opportunities within the region efficiently. As I said, the financial authorities in Asia are working together to develop liquid bond markets, as they expect such markets to facilitate the marriage of savings and investment in the region. Organic linkage of savings and investment would underpin sustainable growth in Asia, thereby contributing eventually to the adjustment of global payment imbalances. Second, socioeconomic infrastructures. In a nutshell, Asia has yet to establish its credentials as an economic area where the rule of law receives due respect. This is particularly crucial since Asia derives enormous benefits from FDI flows via foreign multinationals. In order to sustain FDI inflows, it is of vital importance to provide legal protection of patents, brands, and copyrights. Asia also needs to consolidate a law-abiding and corruption-free business culture to help legal frameworks function effectively. Third, transnational problems. These problems have global dimensions, but they have some Asian features as well. The nightmare of the tsunami disaster is still vivid in our memory, but this region has other weather-related anomalies, including tropical cyclones, floods, droughts, and dust storms, some of which are exacerbated by desertification and deforestation. It is easy to see how these natural disasters decimate our economies. In addition, given the high population density and still-poor sanitation infrastructures in Asia, systematic steps should be taken to contain the spread of lethal epidemics such as avian flu, HIV/AIDS and SARS before they become a global pandemic. The spread of these contagious diseases will virtually halt the cross-border movement of goods and people, thereby causing fatal damage to our economies. Both natural disasters and public health crises call for rapid intervention by the relevant authorities. In order to formulate effective emergency response, we may as well study swiftly a possible region-wide mechanism for surveillance, early warning, and information sharing. Concerted efforts by countries in this region would also make it easier to obtain badly needed international funding for the prevention and mitigation of such human emergencies. Fourth, energy policy. Asian emerging countries are big consumers of energy, while they have little natural resources to count on. This means that, to sustain the present economic rise, these countries need to secure stable sources of energy while developing alternative energy supplies as well. Equally important is a demand-side effort to curtail energy intensity. Better energy efficiency is also helpful in reducing air pollution and green house gas emission. I said earlier that Asian regional cooperation should proceed without rigid boundaries regarding membership. As geography is relative, boundaries should be "open-ended." As far as financial markets are concerned, however, membership can be defined by the time zone. The majority of East Asian countries are located within the 3-hour time band from Sydney to Bangkok. Thus, it is of little surprise that the countries in this zone constitute the core of numerous regional groups. But it will be too naive to assume that Asia alone can handle all the challenges I have described. For instance, we should learn more from the US and Europe when it comes to transparent governance, biomedical technology, public hygiene, and environmental conservation. Being "open-ended" will continue to be an essential element for Asian cooperation. V. Evolving relations with the US Now let me conclude by adding a few words on US-Asia relations. The trans-pacific economic space, spanning Asia and the US continent, explains roughly half the global GDP. In regard to cross-border money flows, the vast portion of Asia's savings are invested in US financial markets, and then recycled back to Asia in the form of FDI by multinationals. The ongoing RMB (renminbi) reform could lead to a substantial change in the monetary landscape between Asia and the US. Given these and other elements I do not cover today, Asia and the US will most likely continue to assume shared responsibility for the smooth functioning of the global economic architecture. Besides the economic issues, Asia's cohesion is as evident as that of Europe. Unlike Europe, however, Asian countries are divided or "linked," I would say, by the sea. Therefore, the safety and stability of sea routes are vital for the cross-border movement of goods, services, and people. With respect to culture, ethnicity, and religion, Asia remains an area of immense diversity. Also, Asia is undergoing profound changes as I said at the outset. Dynamic and diversified perspectives, instead of linear and stereotyped views, help us understand what is going on in Asia, upon which productive USAsia relations develop. As the US-Asia relationship evolves into a multi-layered nexus like a tapestry, it is essential for leaders on both sides of the Pacific to interact closely through prominent forums like the one we are attending today. Let us hope that our trans-pacific ties will continue to be solid on this basis. Thank you for your attention.
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Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at a meeting with business leaders, Nagoya, 8 December 2005.
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Toshihiko Fukui: Overview of the Japanese economy Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at a meeting with business leaders, Nagoya, 8 December 2005. * * * Introduction I understand that this has been a very active and full year here in the Chubu region with the opening of Central Japan International Airport (Centrair) and the success of Expo 2005 Aichi Japan. The Japanese economy has also been recovering its vibrancy, as if absorbing the dynamism of your region. I attended the meeting of the G-7 countries in London last week. The G-7 countries shared the view that overall global economic growth remained and should continue to be solid although there were risk factors such as high crude oil prices and increasing inflationary pressures. In my remarks today, I will present the Bank's view regarding recent economic and financial developments, and explain our thinking on the conduct of monetary policy. The current state of Japan's economy and the outlook Japan's economy continues to recover, having emerged from the temporary pause that began in the second half of 2004. The economy is likely to experience a sustained period of expansion at a pace slightly above its potential. The Bank released the October Outlook for Economic Activity and Prices (the Outlook Report) about a month ago. This Outlook Report projects that such economic growth will continue during the rest of fiscal 2005 and through fiscal 2006. In addition to the continued expansion of overseas economies, another major factor behind the ongoing recovery is that the corporate sector has essentially completed its adjustments of the "three excesses," namely, production capacity, employment, and debt. In relation to the financial system, it may also be noted that financial institutions have now mostly overcome the nonperforming-loan (NPL) problem and recovered their management stability. In the corporate sector, corporate profits have increased for three consecutive years since fiscal 2002, and this trend is continuing during fiscal 2005 with the ratio of profits to sales primarily at large firms surpassing the levels recorded during the bubble era. The semiannual book closings for the first half of fiscal 2005 indicated that high profits were being maintained across a wide range of industries. As a background to the favorable corporate profits over the past three to four years, firms have reduced the "three excesses," and this has been effective in greatly lowering break-even points. Amid these developments, the global economic growth rate accelerated through 2003-04, and domestic private demand has been firmer than predicted in fiscal 2005, pushing up sales and strongly supporting the recent improvement in profits. Domestic private demand has been firmer than expected because while business fixed investment has increased against the background of high corporate profits, strong corporate performance is positively influencing the household sector via increases in wages and employment, as well as increases in dividends and stock prices. According to the Tankan (Short-Term Economic Survey of Enterprises in Japan), large and small firms believe that they are presently facing their greatest personnel shortages in 13 and eight years, respectively. Under these conditions, the number of part-time employees peaked in early fiscal 2005 and the number of full-time employees is growing. Turning to wages per worker, regular payments have been rising, mostly because of increases in wages for full-time employees, and special payments have also been increasing against the background of high corporate profits. According to surveys by private institutions, winter bonuses at large firms for 2005 will increase at a high rate, surpassing the rise in summer bonuses. Consequently, household income continues to rise gradually. Moreover, the dividend income received by households is growing year by year, with the percentage of dividend income against interest income rising from about 40 percent to about 80 percent over the past three to four years. Amid this improvement in the employment and income situation, consumer confidence is generally good and private consumption has been steady. In this manner, a virtuous cycle has begun whereby favorable corporate profits are leading to stronger business fixed investment and spreading to the household sector in various ways, increasing household expenditures and feeding back to the corporate sector via the growth in private consumption. The economy is thus unlikely to fall into a recession due to domestic factors for the time being. Also, as I have mentioned, the financial system has been improving significantly. The percentages of NPLs at financial institutions have declined greatly since they peaked at the end of fiscal 2001, and banks posted record-high profits in their semiannual book closings at the end of September 2005, surpassing those achieved during the bubble era. Bank lending (amount outstanding, after adjusting for the liquidation of loans and loan write-offs), which had long maintained negative growth, began to rise year on year from August 2005. While the corporate sector as a whole continues to repay debt, repayment pressures are gradually easing, and amid the continuing recovery in business conditions some firms are moving ahead with their external funding activities, taking advantage of the accommodative financial environment. Additionally, land price adjustments have advanced, especially in major cities, and the increase in housing-related investment, among others, is another factor contributing to the rise in bank lending. Future risk factors Of course, there are certain risk factors for the economic outlook. The Bank is paying particular attention to the rise in crude oil prices and the developments in overseas economies. Crude oil prices marked a record high around the end of August 2005 (about 70 U.S. dollars/barrel for WTI crude oil) following the hurricane damage in the United States, and have softened somewhat recently, but remain at a rather high level. The rises in crude oil prices in recent years are largely attributable to increased global demand, reflecting developments such as high growth in emerging economies. Therefore, high crude oil prices may be compatible with the expansion of the global economy if both oil-producing countries and oil-consuming countries take adequate actions to deal with increased demand. Nevertheless, as demonstrated by the rapid increase in crude oil prices with the U.S. hurricane damage through the end of August, there is some risk that crude oil prices may shoot up to a level that is not compatible with the demand increase accompanying the expansion of the global economy when there is a keen awareness that refining capacity and other supply constraints are intensifying. If that risk manifests in the future, it may influence the global economy and the economy of Japan by further decreasing the real purchasing power of the non-oil-producing countries and by the full-scale emergence of global inflationary concerns. As for overseas economies, price stability is being maintained in the United States as the Federal Reserve has raised interest rates to prevent the emergence of inflationary pressures while crude oil prices remain at a high level. In Europe and Asia, concern is shifting toward the risks on the inflationary side. The European Central Bank raised interest rates at the beginning of December 2005. The maintenance of an accommodative financial environment under price stability forms part of the background to the expansion of overseas economies in recent years, and a future loss of price stability could change this structure and exert a negative influence on the growth of the global economy. While I mentioned before that the Japanese economy is unlikely to fall into a recession due to domestic factors, we must note that an unexpected slowdown in overseas economies or other large external shocks could decelerate economic growth in Japan. Price conditions and the outlook Turning to price conditions, domestic corporate goods prices are currently rising at a pace slightly below 2 percent year on year, reflecting the increase in crude oil and other international commodity prices and the depreciation of the yen. While the rate of increase is likely to ease, corporate goods prices are projected to continue rising with strong upward pressure. The consumer price index (CPI; excluding fresh food, on a nationwide basis) had been moving slightly below the previous year's levels, but posted a zero percent rise from 2004 in the recently released figures for October 2005. The CPI figures for January through March 2006 are expected to show relatively clear positive year-on-year increases. This is affected by the factors that the negative contribution from lower rice prices has dissipated and the influence from electricity and telephone charge reductions is weakening. In addition, it is affected by the factors that the decline in unit labor costs is shrinking under rising wages, and the gap between supply and demand is narrowing in the Japanese economy as a whole, as indicated by the perceptions of a labor shortage in the Tankan. The year-on-year changes are expected to remain positive thereafter as Japan's economic growth is projected to exceed the potential growth rate. Surveys on price developments also indicated that expectations of prices were being revised upward. Financial market developments Against this background of a positive turn in the outlook for economic activity and prices, net purchases of Japanese stocks by foreign investors have been posting record highs, stock prices have risen substantially, and the Nikkei 225 Stock Average recovered the 15,000 yen level at the beginning of December 2005, the highest level in about five years. Meanwhile, the yen has depreciated further in the foreign exchange market, falling to 121 yen to the U.S. dollar in early December and continuing its declining trend against the euro and Asian currencies. It is said that the recent depreciation of the yen reflects market participants' view on differentials between Japanese and foreign interest rates, given the greater awareness of inflation risk abroad and heightened expectations of higher interest rates. The influence on the economic activity and prices from these financial market developments including the rise in stock prices continues to warrant careful monitoring. The Bank's conduct of monetary policy The Bank has been maintaining the quantitative easing policy since March 2001. The two pillars of the quantitative easing policy are: the Bank's provision of ample liquidity to the money market so that the outstanding balance of current accounts at the Bank substantially exceeds the amount of required reserves of about 6 trillion yen; and the Bank's commitment to continue with this provision of ample liquidity until the year-on-year rate of change in the CPI (excluding fresh food, on a nationwide basis) registers zero percent or higher on a sustainable basis. This commitment is unprecedented as central bank monetary policy, but stipulating the conditions beforehand has made it possible for market participants to act based on the commitment and that has contributed to boosting the transparency and effectiveness of monetary policy. Reviewing the subsequent policy effects, when there were strong concerns about financial system stability, the provision of ample liquidity by the Bank, which met financial institutions' liquidity demand, stabilized financial markets and maintained accommodative financial conditions, and contributed to averting a contraction in economic activity. In financial markets, the Bank's provision of ample liquidity pushed short-term interest rates down to practically zero percent. Longer-term interest rates have remained stably at low levels, because the commitment by the Bank has led the market to expect that the short-term interest rates will remain at zero percent when prices continue to decline. Now that concerns about financial system stability have subsided substantially and prices are beginning to rise, the commitment is losing its influence on the formation of longer-term interest rates. Thus, the effects of the quantitative easing policy are coinciding with the effects of short-term interest rates being at practically zero percent. After the quantitative easing policy is maintained in accordance with the commitment, future monetary policy will follow the path of the processes of "reducing the outstanding balance of current accounts toward a level in line with required reserves," "maintaining very low interest rates," and "gradually adjusting interest rates to a level consistent with economic activity and price developments." In explicating these processes in somewhat greater detail, with respect to the timing for changing the quantitative easing policy framework, the Bank will judge whether the year-on-year rate of change in the CPI registers zero percent or higher on a sustainable basis in accordance with the commitment. Assuming that developments follow the projection described in the Outlook Report, the possibility of meeting the conditions of the commitment and of departing from the present monetary policy framework is likely to increase over the course of fiscal 2006. In reducing the outstanding balance of current accounts, the Bank will need to monitor financial market conditions carefully, because the outstanding balance of current accounts at the Bank has been exceeding substantially the amount of required reserves for a long period of time. Up to this point, the outstanding balance of current accounts, substantially above the level of required reserves, has kept very short-term interest rates practically at zero percent, with some minor fluctuations if any. Considering that the effects of the quantitative easing policy are coinciding with the effects of short-term interest rates being at practically zero percent, a change of the policy framework itself does not imply any major change in the policy effect. If the trend toward positive year-on-year growth in the CPI becomes firmly established, real short-term interest rates will effectively decline, providing powerful stimulus to economic activity and prices. The level and the time-path of interest rates under the subsequent two processes will certainly depend on economic activity and price developments. If it is judged that upward pressure on prices continues to be contained and the economy follows a sustainable and balanced growth path, this is likely to give the Bank latitude in conducting monetary policy. The Bank conducts monetary policy to realize the sustainable growth of the Japanese economy under price stability. At present, the economic recovery is continuing and the environment influencing prices is beginning to change. If the year-on-year rate of change in the CPI registers zero percent or higher on a sustainable basis, that will mark a sort of milestone toward realizing such a goal. The Bank will continue to conduct monetary policy appropriately in accordance with the changes in economic and price conditions to provide support from the financial side for the good performance of the Japanese economy over the long term. Appropriate monetary policy is also important from the perspective of financial market stability. For example, long-term interest rates have remained stable in the United States in part because of market confidence that the appropriate conduct of monetary policy by the Federal Reserve will maintain price stability into the future. In Japan as well, as noted in the Outlook Report, together with the maintenance of appropriate monetary policy, the Bank's explanation of its thinking on the conduct of monetary policy in detail will contribute to smooth formation of prices in financial markets. Closing remarks Chubu is a region that has taken advantage of its manufacturing strengths, vigorously developed private-sector business activities, and pulled the Japanese economy forward. Such originality and inventiveness based on private-sector initiatives will be of the utmost importance for the Japanese economy to realize sustainable growth. In that sense, I look forward to the further remarkable development of the Chubu region.
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Bank of Japan, 20 January 2006.
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Bank of Japan’s January report of recent economic and financial developments 1 Bank of Japan, 20 January 2006. * * * The Bank’s view 2 Japan's economy continues to recover steadily. Exports have continued to increase, and the uptrend in industrial production has become evident. Business fixed investment has continued to increase against the background of high corporate profits. Household income has also continued rising moderately, reflecting the improvement in employment and wages. In this situation, private consumption has been steady. Housing investment has continued to show some strength. Meanwhile, public investment has basically been on a downtrend. Japan's economy is expected to continue to recover steadily. Exports are expected to continue rising against the background of the expansion of overseas economies. Domestic private demand is likely to continue increasing against the background of high corporate profits and the moderate rise in household income, while structural adjustment pressure, such as the excess debt of firms, has almost dissipated. In light of these increases in demand both at home and abroad, production is also expected to follow an increasing trend. Public investment, meanwhile, is projected to remain on a downtrend. On the price front, domestic corporate goods prices have continued to increase, mainly reflecting the rise in international commodity prices and the depreciation of the yen in the second half of last year. The year-on-year rate of change in consumer prices (excluding fresh food) has turned slightly positive. Domestic corporate goods prices are expected to continue increasing for the time being, mainly due to the effects of the rise in international commodity prices. As for the year-on-year rate of change in consumer prices, a positive trend is projected to be established, as supply-demand conditions continue improving gradually and the effects from the reduction in telephone charges dissipate. As for the financial environment, the environment for corporate finance is becoming more accommodative on the whole. The issuing environment for CP and corporate bonds is favorable. Also, the lending attitude of private banks is becoming more accommodative. The lending attitude of financial institutions as perceived by firms has been improving. The pace of decline in credit demand in the private sector is very moderate. Under these circumstances, the rate of increase in the amount outstanding of lending by private banks is accelerating, and the amount outstanding of CP and corporate bonds issued has been above the previous year's level. The year-on-year growth rate of the monetary base is 1.0 percent, and that of the money stock has been around 2.0 percent. As for developments in financial markets, money market conditions continue to be extremely easy, as the Bank of Japan continues to provide ample liquidity. In the foreign exchange and capital markets, the yen's exchange rate against the U.S. dollar and long-term interest rates have been around the same level as last month. Meanwhile, stock prices rose significantly through mid-January, and later fell. They are currently above the level of last month. Japan's economy is expected to deviate slightly above the outlook presented in the Outlook for Economic Activity and Prices (the Outlook Report) released in October last year, as both domestic and external demand continue to increase steadily. As for prices, domestic corporate goods prices are expected to deviate slightly above the outlook, reflecting the rise in international commodity prices and the depreciation of the yen in the second half of last year. Meanwhile, consumer prices are projected to be broadly in line with the outlook. This report is based on data and information available at the time of the Bank of Japan Monetary Policy Meeting held on January 19 and 20, 2006. The text of "The Bank's View" was decided by the Policy Board at the Monetary Policy Meeting held on January 19 and 20, 2006.
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Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, to the Board of Councillors of Nippon Keidanren (Japan Business Federation), Tokyo, 22 December 2005.
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Toshihiko Fukui: The current situation and outlook for Japan's economy Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, to the Board of Councillors of Nippon Keidanren (Japan Business Federation), Tokyo, 22 December 2005. * * * Introduction There is now only one week remaining in 2005. The year has been marked by steady progress toward a new path of growth for Japan's economy, with the completion of adjustments that had been ongoing since the bursting of the bubble. Today, I will focus on the path of Japan's economy in 2006 and onward, talking about the current situation and immediate outlook for economic activity and prices, as well as the challenges facing the economy over the longer term. I. Current economic situation Japan's economy has regained its momentum for recovery, having emerged from the temporary deceleration in economic growth from the second half of 2004. Real GDP in the July-September quarter of 2005 has posted positive growth for the third straight quarter. Japan's economy is likely to experience a sustained period of expansion, albeit at a moderate pace. The current economic expansion has lasted almost four years since January 2002, based on the Cabinet Office's reference dates for business cycles. This already makes it the third longest expansion phase in the post-World War II period, and in the coming year it is appearing increasingly likely to surpass the two other long postwar economic expansion phases, namely the Heisei boom (four years and three months during 1986-91), and the Izanagi boom (four years and nine months during 196570). Japanese stock prices have been increasing in response to the economic recovery. The Nikkei 225 Stock Average recovered to the 15,000 yen level at the beginning of December 2005, its record high for about five years, and even reached the 16,000 yen level temporarily yesterday, December 21. Since the beginning of 2005, the Nikkei 225 Stock Average has risen by more than 30 percent, marking the largest increase among major industrial countries. In the meantime, the net purchase of Japanese stocks by foreign investors has increased substantially. In analyzing business conditions, differences across regions, industries, and firm sizes should of course be taken into consideration. The Bank of Japan collects information via its network of branches spread throughout the country so as to accurately grasp regional developments. Recent information indicates that most regions in Japan have been recovering, although notable differences remain in the degree of improvement: regions with a concentration of high-tech businesses show strength, while those that are highly dependent on public investment remain in relatively severe circumstances. II. Factors behind the moderate and sustainable economic recovery As I mentioned earlier, Japan's economy is likely to experience a sustained period of expansion albeit at a moderate pace in 2006. There are several factors underlying this economic outlook. The first factor is that overseas economies are likely to continue expanding. Japan's exports are expected to continue increasing against the background of this overseas economic expansion. The second factor is that the corporate sector is finally reaching the end of the long path of the postbubble adjustments. Firms have almost resolved their "three excesses" in production capacity, employment, and debt. For example, the recently released December Tankan (Short-Term Economic Survey of Enterprises in Japan) shows that both the number of firms perceiving their production capacity to be insufficient and the number perceiving their holdings of labor to be insufficient have simultaneously exceeded the numbers perceiving them to be excessive for the first time since the bursting of the bubble. Furthermore, ratios of firms' outstanding debt to total assets and to sales have been declining not only at large firms but also small and medium-sized firms. While making adjustments in the "three excesses," firms have responded to economic globalization by reallocating their production bases so as to take advantage of the international division of labor. On the domestic side, they have been reviewing their business lines based on the "selection and concentration" strategy and improving their ability to create high-value-added products and services. As a result, current profits at Japanese firms of all industries and sizes increased for fiscal 2004, with profits and the ratio of current profits to sales exceeding those recorded at the height of the bubble era. Corporate profits are likely to continue to increase for the fourth straight year in fiscal 2005, while absorbing the cost resulting from high crude oil prices. Reflecting high corporate profits, business fixed investment is likely to continue to increase across a wide range of industries. According to the December Tankan, not only have large manufacturing firms substantially increased their business fixed investment plans for fiscal 2005, but small and mediumsized firms have also steadily revised their plans upward. As a result, business fixed investment is expected to increase for the third straight year for firms of all industries and sizes. Financial institutions have mostly resolved their nonperforming-loan problems, which are inextricably linked with firms' excessive debt, and financial institutions' profits have been improving markedly. As a result, financial institutions' lending attitude has become more accommodative, and their lending has been recovering. Financing in capital markets through, for example, issuance of CP and corporate bonds has continued to be favorable, indicating that firms' financing demand is being sufficiently met. These extremely accommodative financial conditions are supporting private demand. The third factor supporting the ongoing economic recovery is the positive interaction which has started to operate between the corporate and household sectors: the positive effects stemming from the increased corporate profits have gradually spread to household income, feeding back to the corporate sector via increased private consumption. Looking at the employment situation, the number of employees has been increasing since 2004, with the number of full-time employees also increasing recently. Regular payments have been increasing steadily, and winter bonus payments are expected to have registered a steady increase. Moreover, increases in receipts of dividends and wealth effects stemming from higher stock prices have started to contribute to the steady developments in private consumption. Reflecting the improvement in the employment and income situation, consumer confidence continues to be favorable on the whole and private consumption is likely to remain steady. Housing investment has shown some strength, as evidenced in housing for sale and housing for rent, reflecting low interest rates. The fourth and last factor supporting the economic recovery, relating back to its moderate pace, is that corporate behavior has remained cautious so that an excessive buildup of stocks, such as production capacity and inventory, is unlikely to occur. The current levels of business fixed investment appear modest relative to the historically high level of current profits. Since cautious corporate behavior will help prevent large economic fluctuations, the economy is likely to experience a sustained period of recovery at a moderate pace. III. Uncertainty over the outlook for economic activity Japan's economy continues to recover steadily and is unlikely to fall into recession due to domestic factors. Nevertheless, in discussing the outlook for Japan's economy, it is necessary to maintain a close watch on the rise in crude oil prices and its impact on developments in overseas economies, including the United States. Crude oil prices have softened somewhat since marking a record high around the end of August 2005, but they still remain at high levels. The high crude oil prices are mainly due to increased global demand, reflecting the expansion of the global economy. But another factor, highlighted by the two hurricanes that recently struck the United States and revealed supply-side weaknesses, particularly in refining capacity, is the risk that the supply of crude oil will fail to meet growing global demand. If crude oil prices rise further due to supply-side constraints, the global economy will be affected by a decline in real purchasing power in non-oil-producing countries, or by rising concerns over increasing inflationary pressures worldwide. In the United States, the Federal Reserve has gradually raised the targeted federal funds rate to above 4 percent. Partly due to these monetary policy actions, the rise in the core consumer price index (CPI) has been contained. However, concern about inflationary risks is emerging due to such factors as the surge in crude oil prices. The current U.S. economic growth has been supported by relatively low long-term interest rates, which have been underpinned by well-contained long-term inflation expectations due to the appropriate conduct of monetary policy. Should, however, price stability be undermined and the financial environment become destabilized, not only would growth in the United States slow, but the global economy could also be affected by abrupt changes in the international flow of funds. Another issue that every country should address in an effort to achieve sustainable global economic growth from a slightly longer-term perspective is increasing global imbalances. At the meeting of the G-7 countries held at the beginning of December in London, the view was shared that each country was taking steps to address these imbalances but more vigorous, mutually reinforcing action was needed. IV. Developments in prices The environment influencing prices has been improving as the economy continues to recover. The output gap is likely to continue narrowing moderately, as the economy continues to recover at a pace slightly above its potential. The decline in unit labor costs is likely to slow along with the increases in wages, despite continued downward pressure from the rise in productivity. Various survey results show that firms' and households' expectations regarding prices are gradually being revised upward. As for the potential growth rate, some argue that it is higher than previously estimated, and thus that the output gap is unlikely to narrow much. It should be noted, however, that a rise in productivity tends not only to expand production capacity but also to stimulate demand via increases in firms' expected growth and households' expected income. Thus, the overall effect on prices of the rise in the potential growth rate varies depending on how these opposing mechanisms work over time. The impact of the expansion of emerging market economies on price developments is increasingly significant. It has been pointed out that the expanding production capacity of emerging market economies, particularly China, has been containing upward pressure on prices. Recently, however, attention is also being paid to another aspect of increased production capacity in these economies, namely, the upward pressure being exerted on crude oil and other raw materials prices. Therefore, in assessing underlying price developments, the effect of relative price changes at the global level should be taken into consideration. Looking at individual price indicators, domestic corporate goods prices are increasing, due mainly to the effects of the rise in crude oil and other international commodity prices and the depreciation of the yen, and they are expected to continue increasing. The year-on-year rate of change in consumer prices (excluding fresh food) had been slightly negative thus far, but posted 0.0 percent in October. The year-on-year rate of change is expected to record a slight increase and remain positive thereafter. As for the outlook, a reduction in electricity charges and other special factors are likely to exert downward pressure on consumer prices from April 2006, the beginning of the next fiscal year. At the same time, there will be other special factors placing upward pressure on consumer prices, so that the net effect remains uncertain. The Bank, however, thinks it unnecessary to change its view that the year-on-year change in the CPI is expected to remain positive in view of the gradual narrowing of the output gap. Land prices on the whole continue to decline, but those in some parts of Tokyo and other major metropolitan areas have started to rise. These developments are notable as they suggest a gradual upturn in people's expectations regarding the future course of the economy. V. Challenges for the future: the declining population The Japanese economy continues to recover steadily, as I mentioned. Looking toward the near future, however, Japan will enter an era of population decline as a result of the declining birthrate of its aging society. According to population statistics, the working-age population (15-64 years old) has already started to decline after peaking in 1995. The total population is projected to peak in 2006, according to the medium variant projection of the National Institute of Population and Society Security Research. It has also been pointed out that the total population is likely to start decreasing earlier than projected. It is assumed that the decline in population will significantly affect the Japanese economy. Supposing that the labor force participation rate remains unchanged, a decline in the total population will cause a decrease in the labor force population. Without substitution of capital for labor or an increase in the rate of technological progress, this decline in the labor force population will lower economic growth. Focusing on the near future, as the baby-boomers reach retirement age between 2007 and 2009, the trend of a decreasing labor force population may accelerate. With a decreasing total population, an increase in the proportion of the aged may also lower the savings rate and lead to deceleration in capital accumulation. In spite of the continued decline in the labor force, I would argue that it is quite possible not only to maintain the current level of per capita income but also to realize a new stage of economic development, if technological progress accelerates and/or economic efficiency is improved. In this regard, economies have the flexibility to respond to demographic changes such as a population decline or population aging. A shortage of labor supply will be at least partly neutralized by increases in the labor force participation rate, induced by, for example, rises in wages. The Japanese industrial structure will change by shifting to capital-intensive industries, transferring the production bases of labor-intensive industries overseas. The Japanese industrial structure will also change in response to the demand for new goods and services accompanying the aging of the population, including nursing care for the elderly. To enable the economy to respond in this way, some crucial adjustments need to be made to the economic and social system as a result of demographic changes. For example, in response to an increase in average life expectancy, it is important to provide reemployment opportunities for people reaching retirement age, ensuring that they are able to work for a longer proportion of their lives. This viewpoint seems important in addressing the problems relating to the retirement of the baby-boomer generation. Furthermore, in order to increase the labor force participation rate for women, it is important to develop social and working environments conducive to balancing work with family life, including public support for childcare. Efforts to improve these environments are expected to neutralize the decline in the labor force. Meanwhile, on the financial side, initiatives taken by financial institutions to accommodate households' portfolio requirements, which are becoming more diversified due to demographic changes, will contribute to greater risk tolerance. Another extremely important point is how we improve productivity in the economy. In addition to increasing the flexibility of the economic structure to allocate limited resources more efficiently, it is deemed necessary to expand the frontiers of Japan's economy by encouraging innovation: technological progress, knowledge creation, and the combination of the two. It should be noted that these efforts will contribute not only to strengthening the supply side of the economy, but also to generating sustainable demand. In other words, by using innovation as a lever to reallocate production resources dynamically to growing sectors, the demand and supply sides of the economy may be expected to expand in a mutually complementary manner. Needless to say, corporate executives, including many of you here today, have already begun to actively engage with these ongoing demographic changes. If, as a result of such efforts, the dynamism of Japan's economy is fully exploited, I think it entirely feasible that the potential of the economy will be enhanced even in the face of a declining labor force. VI. Conduct of monetary policy In closing, let me touch upon the Bank's conduct of monetary policy. The Bank's monetary policy is aimed at contributing to the balanced and sustainable growth of Japan's economy through the pursuit of long-run price stability. As for the conduct of monetary policy in the near future, the Bank will aim to achieve its stated goal by maintaining the framework of the quantitative easing policy based on the clear commitment in terms of the CPI. With the economic recovery likely to remain highly sustainable and the year-on-year changes in the CPI expected to remain positive, the possibility of a departure from the unprecedented framework of the quantitative easing policy, which was introduced to stave off a deflationary spiral, is likely to increase over the course of fiscal 2006. In making this decision, the Bank will judge whether the policy commitment has effectively been fulfilled, that is, whether the year-on-year rate of change in the CPI is registering zero percent or higher on a sustainable basis, by monitoring developments in economic activity and prices. Since, at present, the effects of the quantitative easing policy are increasingly coinciding with the effects of short-term interest rates being at practically zero percent, a change of the policy framework does not in itself imply any major change in policy effects. Such a change is likely to encourage smoother formation of the yield curve in financial markets, thereby invigorating the economy. Although the level of interest rates after such a change of policy framework will of course depend on developments in economic activity and prices, an accommodative financial environment is likely to be maintained, as long as upward pressure on prices continues to be contained and the economy follows a sustainable and balanced growth path. Conclusion Japan's economy is now entering a robust recovery phase, having gone through an adjustment period of more than a decade since the bursting of the bubble. Structural reform of the economy is aimed at stimulating activity in the private sector while managing the economy in a more market-oriented manner. Thanks to deregulation and other government policy measures and private-sector initiatives, the economy is on the threshold of a new growth phase. It is important to make the best of privatesector dynamism by establishing clear prospects for fiscal consolidation while at the same time gaining credibility among the public. The Bank is determined to contribute to the new growth phase of Japan's economy, through its efforts to achieve long-run price stability by the appropriate conduct of monetary policy.
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Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, to the Japan Chamber of Commerce and Industry, Tokyo, 16 March 2006.
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Toshihiko Fukui: New framework for the conduct of monetary policy - toward achieving sustainable economic growth with price stability Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, to the Japan Chamber of Commerce and Industry, Tokyo,16 March 2006. * * * Introduction At the Monetary Policy Meeting (MPM) held on March 8 and 9, 2006, the Bank of Japan decided to terminate the quantitative easing policy, which had been maintained during the five years since March 2001. The Bank shifted the operating target of money market operations from the outstanding balance of current accounts at the Bank to a short-term interest rate, namely, the uncollateralized overnight call rate. It also introduced a new framework for the monetary policy conduct, including clarification of its thinking on price stability. Today, I will focus on the background to the termination of the quantitative easing policy by looking back on economic and financial developments during the past few years, and explain the Bank's future monetary policy conduct. I. Embarking on a sustainable growth path Japan's economy continues to recover steadily. The current economic expansion started in January 2002 and has lasted for more than four years, according to the Cabinet Office's reference dates of business cycles. The recent recovery is well balanced in terms of the balance between domestic and external demand, and also between the corporate and household sectors. Although the recovery is not accelerating, the foundation for economic growth is solid, and its resistance to various external shocks has been increasing. The present phase of the recovery is the third since the bursting of the economic bubble. Unlike the previous two phases, this time we may reasonably expect the current expansionary phase to last longer and to be more sustainable. Japan's economy has, at last, succeeded in emerging from its prolonged adjustment phase, which continued for more than a decade, and has embarked on a sustainable growth path with price stability. Several factors support this view. In addition to external factors, such as the continuing expansion of overseas economies, on the domestic side structural reforms have made significant progress in both the business and financial sectors. Moreover, the positive effects of the recovery are spreading to the household sector. I will now discuss these contributing factors and then go into some detail regarding the sustainability of the current economic recovery. A. Progress in structural reforms The most important factor contributing to the achievement of sustained economic recovery has been the elimination of the burdens, or adjustment pressures, in the corporate sector and the financial system, which have hindered the Japanese economy's movement to a sustainable growth path ever since the bursting of the economic bubble. As a result of stringent corporate restructuring efforts that lasted for more than a decade, the excesses in debt, employment, and production capacity -- the so-called "three excesses" -- have for the most part been dispelled and resolved. According to the latest Tankan (Short-Term Economic Survey of Enterprises in Japan), the number of firms perceiving their production capacity as excessive is almost equal to the number perceiving it as insufficient for the first time since the early 1990s. The number of firms perceiving their holdings of labor as insufficient has already exceeded the number perceiving them as excessive, indicating that firms perceive a tightening of the labor market. This tightness is also evidenced by the ratio of job offers to applicants, which has exceeded 1.00. Turning to firms' debt levels, the ratio of interest-bearing debt to sales peaked out around 1993, and is currently as low as that seen in the mid-1980s, before the bubble era. While taking measures to resolve the "three excesses," firms have been reviewing their business lines based on the principle of "selection and concentration" in the face of intensified global competition. More specifically, firms have adopted an active management approach by concentrating on strategic areas of business and establishing business tie-ups to improve their ability to generate high-valueadded products and services. As a result, firms have succeeded in substantially improving their profitability. Corporate profits have increased for the three consecutive years from fiscal 2002, and are expected to continue to increase in the current fiscal year. Firms' ratio of current profits to sales has already exceeded the peak marked during the bubble era. Using the high level of corporate profits, firms are actively investing in research and development and expanding production capacity in order to boost market competitiveness. These activities are evident in increases in business fixed investment, regardless of the type and size of firm. Improvements are also notable in the financial system. The nonperforming-loan (NPL) problem that has plagued Japan's economy for so long has by and large been resolved, and the stability of the Japanese financial system has been restored. The lending attitude of financial institutions has become more active as a result of improvements in their profitability and capital adequacy ratios due to the decrease in the amount of NPLs. The amount outstanding of lending by private banks, which had long been on a downward trend, finally turned upward on a year-on-year basis in August 2005 after an adjustment for securitization of loans and loan write-offs. Since then, the pace of increase has been gradually accelerating. In the previous two recovery phases, weakness in the financial system hindered the economy from moving onto a sustainable growth path. At present, however, the financial system has recovered to a level of soundness sufficient to firmly support the achievement of sustained economic growth. B. Spread of improvement in the corporate sector to the household sector In order to realize a sustainable economic recovery, it is important for a virtuous cycle to operate in the economy, wherein the improvement in income of the corporate sector spreads to the household sector, and this in turn feeds back to the corporate sector. Unfortunately, in past recovery phases, such a virtuous cycle did not fully operate, as both the corporate sector and the financial system were subject to structural adjustment pressure. In contrast, in the current recovery phase, apparent improvement in the employment and income situation has been observed since the beginning of 2005, and a longer and more sustainable recovery is expected in the household sector. Firms have been increasing their numbers of employees, as the adjustment in excessive holdings of labor has progressed. Initially, they relied mainly on part-time workers in order to restrain labor costs, but firms have begun to gradually increase their numbers of regular employees, as the labor market has tightened. Wages per worker have also been rising, reflecting such conditions in the labor market. Specifically, regular payments have recently begun to increase in addition to continuing growth in overtime payments and bonus payments. This improvement in the employment and income situation, coupled with a rise in stock prices and an increase in dividend income, has contributed to income growth in the household sector. With such income conditions, private consumption has been solid. It is expected to remain so, supported by the increase in household income. This development is expected to accelerate the virtuous cycle further as the firmness in private consumption feeds back to the corporate sector. As seen from what I have described, Japan's economy continues its solid recovery, but this recovery is often said to not apply evenly across small firms and regional economies. In fact, the degree of recovery still varies according to size of firm and region. The economic recovery has indeed been spreading steadily, with both domestic and external demand continuing to increase. The Tankan indicated that business conditions at not only large firms but also small and medium-sized ones have been improving. The Bank's branches conduct research and interviews so as to grasp the state of regional economies, and the results are presented at the meeting of general managers of the Bank's branches. The results show that, although there still is a difference in the degree of recovery, all regional economies are showing improvement. The Bank will continue to pay due attention to future developments in regional economies. II. Improvement in the environment for prices The environment for prices has become favorable reflecting the continuing economic recovery. The year-on-year rate of change in the consumer price index (CPI, excluding fresh food) had been negative since 1998, but returned to 0.0 percent in October 2005 and turned positive in November. According to the figure released on March 3, 2006, it rose further in January 2006, reaching 0.5 percent. This was partly attributable to the dissipation of temporary factors such as the reduction of telephone charges implemented in 2005 and also to high crude oil prices, but more importantly, fundamental factors that affect price developments clearly began to improve and started to exert upward pressure on prices. First, the supply-demand balance is improving gradually and improvement is expected to continue, as the economy continues to recover at a pace slightly above its potential. Second, although unit labor costs continue to be driven down by the productivity increase, with wages beginning to rise, the rate of decline has been diminishing and this trend is expected to continue. And third, firms' and households' expectations of inflation have been gradually revised upward, as indicated by various surveys. All of this indicates that the environment for prices has changed dramatically from the past, when a substantial output gap exerted downward pressure on prices. As the economy is expected to continue to recover steadily with a balance being maintained between domestic and external demand and between the corporate and household sectors, a positive trend in the year-on-year rate of change in consumer prices is projected to be established, albeit with some fluctuations. As I have explained, Japan's economy has achieved substantial improvement, in terms of both economic activity and prices, and this implies that the Bank should respond to the improvement by changing its conduct of monetary policy. III. Effects of the quantitative easing policy The Bank displayed its resolve in continuing the quantitative easing policy for five years after introducing it in March 2001. At the time, Japan's economy was in a recessionary phase triggered by the collapse of the IT bubble around the globe. Financial institutions in Japan were also burdened by massive NPLs, and there was a high level of public anxiety concerning the stability of the financial system. In these circumstances, the economy faced a severe challenge, the potential risk of falling into a vicious cycle, or so-called deflationary spiral, in which a fall in demand reflecting deterioration of the economy causes a decline in prices and this in turn leads to a further fall in demand. To counter this situation, the Bank acted decisively and introduced the quantitative easing policy, which was unprecedented in the history of any central bank, with the aim of preventing a continuing fall in prices and establishing a foundation for achieving sustainable economic growth. I would like to elaborate on what the quantitative easing policy has contributed to Japan's economy over the past five years. The quantitative easing policy consisted of two pillars: provision by the Bank of ample liquidity to raise the outstanding balance of current accounts at the Bank above the amount of reserves financial institutions are required to hold, namely, required reserves; and a commitment by the Bank to continue to provide ample liquidity until the year-on-year rate of change in the CPI (excluding fresh food) registered zero percent or higher on a sustainable basis. Provision of ample liquidity exceeding required reserves reduced very short-term interest rates to effectively zero percent and dispelled financial institutions' liquidity concern. After the introduction of the quantitative easing policy, there was no occurrence of any large-scale credit crunch, such as was observed in 1997 and 1998, and stability in financial markets was maintained despite the materialization of various shocks, including the terrorist attacks in the United States and the Iraq war as well as the injection of public funds into a major Japanese bank when the financial system was fragile. The Bank's commitment to continue the quantitative easing policy generated expectations that the zero interest rate environment would continue for a certain period of time while consumer prices continued to decline. This is referred to as the "duration effect," that is, the effect of the Bank's commitment regarding the duration of the policy. As a result of this duration effect, the Bank's commitment contributed to keeping short- to medium-term interest rates stable at low levels. The policy effects of dispelling the liquidity concern as well as keeping interest rates low and stable have created an accommodative environment not only in the money market and capital markets but also in corporate finance activities. Bank lending rates, for example, have continued to decline partly reflecting the decrease in the credit premium, and are around historically low levels, despite the ongoing economic recovery. As mentioned earlier, Japanese firms, after strenuous efforts, have tackled structural problems such as the "three excesses," and are becoming increasingly active in undertaking business fixed investment. The accommodative financial environment created by the quantitative easing policy has been firmly supporting such developments. It could be said that the policy has contributed to improving the rate of return on capital and to raising corporate profits, as it enabled lending rates to decline even while the economic outlook was gradually brightening. These improvements in the corporate sector have, with a certain lag, been exerting positive effects on the household sector, thereby supporting the continuing economic recovery and the favorable environment for price developments. The Bank's quantitative easing policy played a significant role in the recovery of Japan's economy and in the improvement in price developments. However, amid recent economic and financial circumstances, both the effect of the quantity of liquidity to dispel liquidity concern and the duration effect through which the Bank's commitment influences interest rates are considered to have played themselves out. As the financial system has regained stability, liquidity demand at financial institutions has declined, reducing the need for the provision of funds at a level well over required reserves. In addition, the duration effect of the policy commitment has been gradually diminishing with the shortening of the expected duration of the quantitative easing policy in line with the improvement in price developments. Ultimately, the duration effect ceases to exist when the criterion that the year-onyear rate of change in the CPI is registering zero percent or higher on a sustainable basis is fulfilled. In short, the effects of the quantitative easing policy on economic activity and prices had already become essentially equivalent to those of an interest rate policy targeting a short-term interest rate of zero percent prior to the termination of the quantitative easing policy. IV. Background to the termination of the quantitative easing policy In this situation, the Bank decided to terminate the quantitative easing policy at the MPM held on March 8 and 9, 2006. The Bank decided to change the operating target of money market operations from the outstanding balance of current accounts at the Bank to the uncollateralized overnight call rate, and to set the guideline for money market operations for the intermeeting period as follows: "The Bank of Japan will encourage the uncollateralized overnight call rate to remain at effectively zero percent." The year-on-year rate of change in the CPI has been registering zero percent or above for the four consecutive months since October 2005, and a positive trend in the rate of change in the CPI is projected to be established. Economic developments underlying the CPI also indicate that Japan's economy is likely to experience a sustained period of expansion with domestic and external demand well in balance. Based on these developments in economic activity and prices, the Bank judged that the commitment that it would continue the quantitative easing policy until the year-on-year rate of change in the CPI registers zero percent or higher on a sustainable basis had been fulfilled, and that it was therefore appropriate to terminate the unprecedented quantitative easing policy. It must be stressed that the termination of the quantitative easing policy does not signify a tightening of monetary policy. As I have explained, the policy effects of the quantitative easing policy have already become essentially equivalent to those of an interest rate policy targeting a short-term interest rate of zero percent. Since the Bank will encourage the uncollateralized overnight call rate to remain at effectively zero percent based on the new guideline for money market operations, there will be no abrupt change in monetary policy in terms of the stimulative effects of the quantitative easing policy on economic activity and prices. The effects of short-term interest rates being at effectively zero percent have increased gradually with the upturn in economic activity and prices, and they are expected to become stronger while the current guideline is maintained. Although the level of interest rates depends on developments in economic activity and prices as well as in financial markets, if it is judged that inflationary pressures are restrained as the economy follows a balanced and sustainable growth path, then the accommodative monetary environment ensuing from very low interest rates will probably be maintained for some time. The Bank will continue to offer firm support to the economy by maintaining accommodative monetary conditions. Some might question why the Bank should terminate the quantitative easing policy if the policy effects are equivalent to those of an interest rate policy targeting a short-term interest rate of zero percent. However, the Bank made a clear commitment when it introduced the quantitative easing policy that it would continue the policy until the year-on-year rate of change in the CPI registered zero percent or higher on a sustainable basis, and market participants have been conducting transactions on this premise. The duration effect of the policy commitment could not have been achieved without market participants' confidence in the commitment. In this regard, the termination of the quantitative easing policy once the Bank judged the commitment to have been fulfilled contributes to enhancing monetary policy transparency and in turn the effectiveness of monetary policy in the long term. Putting this another way, if the Bank had continued to conduct monetary policy in line with an operating target that had already essentially lost its effectiveness, this could well have caused not only increased uncertainty in financial markets but also damage to the transparency of monetary policy. V. Conduct of money market operations for the immediate future In conducting money market operations in the immediate future, the Bank will reduce the outstanding balance of current accounts toward a level in line with required reserves according to the new guideline for money market operations. It should be borne in mind, however, that as financial institutions have managed liquidity against the backdrop of large amounts of current account balances and extensive funds-supplying operations by the Bank for a prolonged period under the quantitative easing policy, the functioning of the money market has been somewhat impaired. As a result, financial institutions may have difficulties carrying out smooth fund management. Given these circumstances, the Bank's reduction of the current account balance will be implemented taking full account of conditions in the money market. How long it will take for the Bank to reduce the current account balance depends on the situation in the money market, but it is reasonable to expect the reduction to be carried out over a period of a few months. With respect to the complementary lending facility, which allows financial institutions to borrow short-term funds from the Bank at their request up to the amount of the collateral they pledged in advance, the Bank decided to keep the loan rate unchanged at 0.1 percent, its level prior to the termination of the quantitative easing policy. This means that the uncollateralized overnight call rate, which will be effectively zero percent in accordance with the new guideline for money market operations, will basically not exceed this ceiling of 0.1 percent even if it surges temporarily. Reduction of the outstanding balance of current accounts at the Bank will be managed through short-term money market operations. With respect to outright purchases of longterm Japanese government bonds, these will continue at the current amounts and frequency for some time, with due regard for the future condition of the Bank's balance sheet. VI. Introduction of a new framework for the conduct of monetary policy Following the latest MPM, the Bank announced the introduction of a new framework for the conduct of monetary policy, with a view to ensuring the transparency of its policy conduct given the shift from the quantitative easing policy to an interest rate policy. Under the quantitative easing policy, the Bank conducted monetary policy in line with a commitment based on the CPI. The commitment was unprecedented in that it linked the conduct of monetary policy directly to a specific economic indicator, namely, the CPI. With the aim of generating monetary easing effects in a situation where there was no room to further reduce short-term interest rates, the Bank introduced this unprecedented policy to affect the formation of interest rates, in spite of acknowledging the concomitant sacrifice in the flexibility with which it would be able to conduct monetary policy. Such a policy measure had never previously been adopted by any central bank, and it may safely be seen as a monetary policy innovation designed by the Bank of Japan. As I explained earlier, the Bank's commitment regarding the duration of the policy had significant positive effects that operated by keeping short- to medium-term interest rates stable at low levels and maintaining an accommodative environment for corporate financing. However, at the same time, the policy to some extent undermined the pricing function of financial markets. With the prospects for sustainable economic growth with long-term price stability, monetary policy in general should be conducted in a forward-looking manner -- in other words, it should be implemented taking future developments in economic activity and prices fully into consideration -- and it should be both flexible and timely. In the current situation where the economy is emerging from a prolonged period of structural adjustment and moving toward a path of sustainable growth, a new framework should be introduced to ensure that monetary policy is conducted both appropriately and with sufficient transparency. Given the Bank's thinking about the conduct of monetary policy, market participants, for their part, should have their own views on interest rate developments and thereby make decisions on financial transactions, by forecasting the future course of monetary policy based on their assessment of economic activity and prices. Such a process will facilitate the proper functioning of pricing mechanisms in financial markets and in turn generate economic dynamism through the efficient allocation of funds. Three elements underlie the new framework for the conduct of monetary policy. First, the Bank has clarified its thinking on price stability, which is a stated objective of monetary policy. Specifically, the Bank has made public its basic thinking on price stability, and, as regards the conduct of monetary policy, it has disclosed a level of the inflation rate that its Policy Board members currently understand as price stability from a medium- to long-term viewpoint. Second, the Bank has explained the two perspectives from which it examines economic activity and prices in determining how to conduct monetary policy. Third, the Bank has decided that, after deliberations from these two perspectives, it will outline its thinking on the conduct of monetary policy for the immediate future, and, as a rule, disclose it periodically in the Outlook for Economic Activity and Prices (hereafter the Outlook Report). Now I will elaborate on these three elements. A. Clarifying the Bank's thinking on price stability The Bank of Japan Law stipulates the objective of monetary policy as "contributing to the sound development of the national economy" "through the pursuit of price stability." In accomplishing this stated objective, it is thus very important for the Bank to clearly indicate to the public its thinking on price stability. Price stability can be defined as a state where various economic agents including households and firms are able to make decisions regarding economic activities such as consumption and investment without being concerned about fluctuation in the general price level. When considering what constitutes price stability for the purposes of conducting monetary policy, central banks should take full account of the distinctive features of their countries' economic structures and how these influence the public's view of prices. In the case of Japan, one noteworthy feature regards the average rate of inflation, which, over the last a few decades, has been lower than in major overseas economies. Specifically, average inflation rates for major countries from 1985 to 2005, measured by the CPI, are as follows: 3.2 percent for the United States, 2.9 percent for the United Kingdom, 1.8 percent for Germany, and 0.6 percent for Japan. As the Japanese economy has had a protracted experience of low inflation since the 1990s, the rate of inflation at which households and firms perceive price stability seems to be low, and economic decisions are likely to be made on the premise of a similarly lowinflation environment. These features should be taken duly into consideration when conducting monetary policy. At the latest MPM, taking into account the points I have described, there was a discussion of the level of inflation that each Policy Board member, in conducting monetary policy, currently understands as price stability from a medium- to long-term viewpoint. Such a level is referred to as a member's "understanding of medium- to long-term price stability." There was a range of views among the Policy Board members, which seemed to reflect differences between their views on the Japanese economic structure, as well as differences in their assessments of the costs of inflation and deflation. They concurred, however, that, in the current situation, the level in Japan was somewhat lower than in major overseas economies. They also agreed that, by making use of the rate of year-on-year change in the CPI to describe the understanding, an approximate range between zero and 2 percent was generally consistent with the distribution of each member's understanding of medium- to long-term price stability. Most Policy Board members' median figures fell on both sides of 1 percent. Given that the "understanding of medium- to long-term price stability" may change gradually, reflecting changes in the economic structure such as further progress in globalization and innovations in information and communication technologies, as a rule, Policy Board members will review it annually. B. Examining economic activity and prices from two perspectives Having clarified its thinking on price stability, the Bank's next step was to decide how to examine economic activity and prices in light of such thinking, and then to devise ways to incorporate such analysis into its conduct of monetary policy. Although it is very important to clarify the Bank's thinking on price stability, this in itself is not sufficient to develop an actual policy guideline for conducting monetary policy. The most significant issue facing any central bank, regardless of whether it has adopted inflation targeting or not, is how to provide information that will make it easier for the public to predict the future course of monetary policy and so enhance its effectiveness. For instance, suppose a central bank conducts policy based on certain mechanical rules. Although such rules would in themselves enhance the transparency of the policy, they would be incapable of coping flexibly with the various economic shocks hitting the economy. They would therefore fail to meet the original purpose of enhancing transparency, which is to improve the effectiveness of monetary policy. To date, the Bank has released its assessment of the current state and outlook for economic activity and prices through the Monthly Report of Recent Economic and Financial Developments and the Outlook Report. Henceforth, the Bank has decided to supplement this assessment with additional examinations of economic activity and prices from the following two perspectives, which are of particular relevance to the conduct of monetary policy, and then to release them. The first perspective involves examining, as regards economic activity and prices one to two years in the future, whether the outlook deemed most likely by the Bank follows a path of sustainable growth under price stability. It should be added that, in order to implement the appropriate policy for achieving sustainable growth and price stability, it is not sufficient merely to assess the economic and price situation according to the first perspective. Needless to say, any forecast entails uncertainty. It is for this reason that the Bank's Outlook Report contains detailed descriptions with regard to upward and downward risks affecting the scenario deemed most likely by the Bank. Among risk factors, there are those that will have a significant impact on economic activity and prices should they materialize, even though the likelihood of materialization is low. Such risks include that of falling into a deflationary spiral, or conversely, the risk of sparking inflation or generating an asset price bubble. In conducting monetary policy, the Bank needs to do its utmost to prevent the materialization of such potential risks. The economic projection described in the Outlook Report covers a period of about one and a half to two years. There could, however, be risk factors that might affect economic activity and price development in the medium to long term, beyond the Outlook Report's projection period. Experience inside and outside Japan shows that wide swings in asset prices and significant changes in the financial environment, including those affecting the intermediation function of financial institutions, may impact on economic activity and price development with a considerable lag. In addition, when the public's longer-term expectations of inflation change, this can have a significant impact on the existing relationship between economic activity and prices. The second perspective, therefore, involves examining, over a longer horizon, the various risks that are most relevant to conducting monetary policy aimed at realizing sustainable growth under price stability. Major central banks seem to share the opinion that to conduct monetary policy putting too much emphasis on achieving price stability in the short term results in large swings in economic activity, and this in turn impedes long-term price stability and the sound development of the economy. C. Conduct of monetary policy for the immediate future Lastly, as the third element of the new framework for the conduct of monetary policy, the Bank will outline its current view on monetary policy in light of its deliberations from the two perspectives I have described, and disclose it periodically, as a rule in the Outlook Report. On the current occasion, the Bank decided to release the results of its deliberations ahead of the release of the April Outlook Report, to coincide with the timing of the termination of the quantitative easing policy. Looking ahead, in considering the central scenario for economic activity and prices, there is a high probability of realizing sustainable growth under price stability. As I mentioned earlier, however, against the backdrop of improving corporate profitability and a positive turn in price developments, there is a possibility that the monetary policy stimulus to economic activity and prices could be amplified via, for example, a decline in real interest rates. If the stimulus becomes too strong, there is a risk that, even if current prices are stable, investment activity could become excessive, resulting in volatile economic fluctuations. Moreover, this could negatively affect the prospects for sustainable economic growth with long-term price stability. In its conduct of monetary policy, the Bank should pay attention to this as well as other long-term risks. Bearing this in mind, I would now like to touch on the Bank's thinking regarding the future path of monetary policy. There will be a period in which the uncollateralized overnight call rate is at effectively zero percent, followed by a gradual adjustment in light of developments in economic activity and prices. In this process, if the risk I have described remains muted, in other words, if it is judged that inflationary pressures are restrained as the economy follows a balanced and sustainable growth path, an accommodative monetary environment ensuing from very low interest rates will probably be maintained for some time. This completes my explanation of the new framework for conducting monetary policy introduced last week. The Bank and other central banks make continuous efforts to clearly explain their thinking on the conduct of monetary policy to market participants and the public. The specific method employed, however, differs according to their economic environment and institutional framework. At the Bank, in introducing a new framework we studied practices at other central banks and adopted the elements that were considered relevant, but most importantly we devised the most appropriate framework for clearly explaining the conduct of monetary policy in light of Japan's economic situation. Although the new framework is different from, for example, inflation targeting, where a numerical target for price stability is set and is to be achieved within a certain time frame, nevertheless the new framework improves the transparency of the Bank's monetary policy objective by indicating its thinking on what constitutes price stability. Taking this into account, the Bank will examine economic activity and prices from the two perspectives explained earlier, and will release its view on the conduct of monetary policy for the immediate future. For Japan's economy, which has emerged from a prolonged recession and is entering a new phase, the Bank believes that the new policy framework is the most suitable for enhancing transparency and conducting monetary policy appropriately. This new framework is also expected to contribute to smooth price formation in financial markets where participants find themselves in uncharted territory with the termination of the unprecedented quantitative easing policy. Conclusion Today, I have elaborated on the current state of Japan's economy, which is entering a new phase, as well as providing details about the new framework for conducting monetary policy introduced last week. Under the new framework, the Bank will continue to conduct monetary policy appropriately, responding flexibly to changes in economic activity and prices, and to contribute to sustainable economic growth and price stability.
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Statement by Mr Toshihiko Fukui, Governor of the Bank of Japan, before the Committee on Financial Affairs, House of Councillors, Tokyo, 21 February 2006.
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Toshihiko Fukui: Semiannual report on currency and monetary control Statement by Mr Toshihiko Fukui, Governor of the Bank of Japan, before the Committee on Financial Affairs, House of Councillors, Tokyo, 21 February 2006. * * * Introduction The Bank of Japan submitted its Semiannual Report on Currency and Monetary Control for the first half of fiscal 2005 to the Diet in December 2005. I am pleased to have this opportunity to present an overall review of the Bank's conduct of monetary policy. I. Developments in Japan's economy The growth of Japan's economy slowed temporarily from the second half of 2004 to the summer of 2005. Thereafter, it emerged from this pause and has continued to recover steadily. Exports and industrial production have continued to increase. Business fixed investment has continued to increase against the background of high corporate profits. In the household sector, household income has been rising moderately, as the number of employees has been increasing and wages have picked up. With this improvement in the employment and income situation, private consumption has been steady. Looking forward, exports are expected to continue rising against the background of the expansion of overseas economies. Domestic private demand is likely to continue increasing reflecting high corporate profits and the moderate rise in household income, while structural adjustment pressure, such as the excess debt of firms, has almost dissipated. Given that an environment in which a virtuous cycle can start operating has been established with the recovery both in domestic and external demand and in the corporate and the household sectors, the economy is likely to experience a relatively long period of growth, albeit at a moderate pace. Nevertheless, risk factors such as the continuing surge in crude oil prices and its possible effect on overseas economies should continue to be monitored closely. On the price front, the environment influencing prices has been improving. The output gap has been narrowing moderately, as the economy continues to recover at a pace above its potential. The decline in unit labor costs has been slowing with the increases in wages, despite continued downward pressure from the rise in productivity. Various survey results show that firms' and households' expectations regarding prices are gradually being revised upward. As for price indexes, domestic corporate goods prices registered the largest increase on a year-onyear basis since March 1990, mainly reflecting the rise in international commodity prices and the depreciation of the yen in the second half of 2005, and are expected to continue increasing. The yearon-year rate of change in consumer prices (excluding fresh food, on a nationwide basis) had been slightly negative, but posted a slight increase for two consecutive months in November and December 2005. The year-on-year rate of change is likely to record a relatively clear increase in January 2006 and thereafter as the effects from the reduction in telephone charges dissipate. A positive trend is likely to be established thereafter, as the output gap continues improving gradually and downward pressures from unit labor costs decrease. On the financial front, the environment for corporate finance is becoming more accommodative on the whole. The issuing environment for CP and corporate bonds is favorable and the lending attitude of private banks is becoming more active. The decline in credit demand in the private sector is coming to a halt. Under these circumstances, the amount outstanding of CP and corporate bonds issued has been above the previous year's level and the year-on-year rate of increase in the amount outstanding of lending by private banks, after adjusting for the liquidation of loans and loan write-offs, has been accelerating since August 2005 when the year-on-year rate of change turned positive. Land prices remain generally on a downtrend, but the pace of decline has been slowing recently and in some areas such as central Tokyo they have started to rise. II. Conduct of monetary policy The Bank has been providing ample liquidity based on the quantitative easing policy. At the Monetary Policy Meeting on February 8 and 9, 2006, the Policy Board decided to maintain the target range for the outstanding balance of current accounts held at the Bank at "around 30 to 35 trillion yen." The framework of the quantitative easing policy is based on two key elements. The first element is the Bank's provision of ample liquidity to the money market so that the outstanding balance of current accounts at the Bank substantially exceeds the amount of required reserves. The second is the Bank's commitment to maintain this ample provision of liquidity until the year-on-year rate of change in the consumer price index (CPI) registers zero percent or higher on a sustainable basis. The effects of the quantitative easing policy have been changing with developments in economic activity and prices as well as the state of the financial system. When there were strong concerns over the stability of the financial system, the Bank's ample provision of liquidity, which met financial institutions' liquidity demand, stabilized financial markets and maintained accommodative financial conditions, and thus contributed to averting a contraction in economic activity. In the current situation, the financial system in Japan has regained stability mainly because financial institutions have mostly resolved their nonperforming-loan problems, and as a result financial institutions' precautionary demand for liquidity has declined substantially. The year-on-year rate of change in the CPI has become slightly positive recently, and therefore the policy commitment has to a significant extent lost its influence on the formation of longer-term interest rates. Thus, the stimulative effects of the quantitative easing policy on economic activity and prices are coinciding with the effects of short-term interest rates being at practically zero percent. The effects of monetary easing are being amplified by low interest rates maintained during the improvement in economic and price conditions. Given this situation, the Bank will thoroughly examine economic activity and prices, and decide a change of the policy framework appropriately according to the commitment based on the CPI. Conclusion Japan's economy continues to recover steadily. The current economic expansion has lasted four years, since January 2002, based on the Cabinet Office's reference dates of business cycles. This already makes it the third-longest expansion phase in the post-World War II period. As for the outlook, the economy is likely to experience a relatively long period of growth, albeit at a moderate pace, and the Bank will continue its close monitoring of developments. The Bank will also continue to examine the state of the economy in each region thoroughly through such means as research conducted by its branches. The Bank conducts monetary policy to realize sustainable growth of the economy through the pursuit of price stability. The Bank is determined to firmly support Japan's economy from the financial side to achieve sustainable growth with price stability by maintaining an accommodative financial environment, based on careful examination of developments in economic activity and prices.
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Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, to the Naigai Josei Chousa Kai (Research Institute of Japan), Tokyo, 15 May 2006.
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Toshihiko Fukui: The outlook for Japan's economy and the conduct of monetary policy Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, to the Naigai Josei Chousa Kai (Research Institute of Japan), Tokyo, 15 May 2006. * * * Introduction Japan's economy has been recovering for more than four years since the trough in January 2002. The Bank of Japan projected in its Outlook for Economic Activity and Prices (hereafter the Outlook Report) released on April 28, 2006 that from fiscal 2006 through fiscal 2007 the economy was likely to experience a sustained period of expansion, with domestic and external demand and also the corporate and household sectors well in balance. Today, I will focus on the Bank's view concerning future developments in economic activity and prices given the projection in the Outlook Report, and I will explain its future monetary policy conduct. I. Developments in the world economy I will first touch on developments in the world economy, which underlie developments in Japan's economy. The world economy has been expanding steadily since 2003, recording a growth rate of around 5 percent in 2005, and is projected to maintain high growth into the future. At the G-7 meeting held in Washington, D.C., in April 2006, finance ministers and central bank governors agreed that the outlook for the world economy remained favorable, although risks remained from factors such as oil market developments and global imbalances. They also agreed that inflation remained contained despite high oil prices and that global trade growth was buoyant. Economic developments among Japan's main trading partners indicate that the U.S. economy continues to expand steadily, at a pace around its potential growth rate, led mainly by business fixed investment and household spending, although there are signs of a slowdown in some parts of the economy, specifically in the housing market. The Chinese economy continues to expand strongly as a whole despite some imbalance in the pace of growth between industries and regions. The NIEs and ASEAN economies continue to expand at a moderate pace on the whole, although the negative effects of high energy prices can be seen in some areas of economic activity. II. Current situation and outlook for Japan's economy Turning to Japan, the economy continues to recover steadily. One of the characteristics of the current economic situation is that domestic and external demand and also the corporate and household sectors are well in balance. Exports continue to increase against the backdrop of global economic expansion and trade expansion resulting from further progress in international division of the production process. As for domestic private demand, corporate performance continues to be strong. The Bank's Tankan (Short-Term Economic Survey of Enterprises in Japan) indicates that corporate profits increased for the fourth consecutive fiscal year, and firms expect their sales and profits to rise in fiscal 2006. Business fixed investment plans for fiscal 2006 are relatively strong. As for the household sector, the employment and wage situation has been improving and private consumption has been on an increasing trend. Japan's economy is likely to continue to show balanced growth. Another characteristic is that the sustained economic recovery has resulted in a higher level of utilization of resources such as capital and labor. The current recovery has already lasted for over four years, and if it continues much longer, in October 2006 it will equal the Izanagi boom (1965-70), which is the longest postwar economic expansion to date. As a result of the sustained recovery, according to the Tankan, for the first time in more than a decade firms are no longer perceiving excess capacity but have started to feel more strongly that their labor holdings are insufficient. The ratio of job offers to applicants, below 1.00 from 1992 until recently, has now exceeded 1.00 since the end of 2005. Furthermore, the conditions of persistent oversupply have been dispersed and the output gap, the difference between actual and potential output, which had long been negative, seems now to have closed. This indicates that demand and supply capacity in the economy are well balanced. Given these characteristics of the current economic situation, the following are considered to be the three core elements of the most likely projection for economic activity and prices two years into the future. The first element is that the household sector is expected to be the main driving force behind firm domestic private demand. Strong corporate performance has been benefiting the household sector, and this positive influence is likely to become more evident from now on. Employment and wages have been improving against the background of favorable corporate profits and rises in labor shortages. The number of part-time employees and bonus payments are rising, and the number of full-time employees and regular payments are also on an uptrend. These developments suggest that households can expect the increase in their income to be more permanent, and this has contributed to the improvement in consumer sentiment. Households' average propensity to consume is likely to remain at its current elevated level, and private consumption is expected to follow an increasing trend. Housing investment is likely to continue to trend moderately upward, supported by the improvement in household income and the view that interest rates will only rise from current levels, as land prices are starting to rise particularly in major metropolitan areas. Increases in household spending will feed back to the corporate sector via increases in sales and profits, and thus, a virtuous circle between the household and corporate sectors is likely to keep operating. The second element is that there is likely to be a cyclical slowdown in the economic growth rate as the recovery has already lasted for over four years and is likely to mature. Given the high level of corporate profits and the expansion in domestic and external demand, the momentum driving increases in business fixed investment is likely to be maintained. However, considering that there is a stable relationship in the long term between the capital stock and aggregate demand, the pace of increase in business fixed investment will probably slow eventually. Business fixed investment has steadily increased for the third consecutive year since fiscal 2003, and this has resulted in high growth in the capital stock relative to the projected increase in aggregate demand. Therefore, unless firms can make stronger forecasts for the economic growth rate and the rate of return on investment, it is becoming unlikely that they will keep up the current pace of increase in business fixed investment. In this situation, the growth rate of Japan's economy is likely to slow toward the potential growth rate, which the Bank estimates to be in the 1.5-2 percent range. The forecast is around 2.5 percent for fiscal 2006 and around 2 percent for fiscal 2007. The third element is that, as the economic recovery matures, a slowdown in the growth in productivity and upward pressure on wages are expected to exert upward pressure on prices. At an early stage of economic recovery, firms usually retain surplus labor and capacity and are therefore able to increase productivity by raising their rate of resource utilization. With the maturing of the economic recovery, however, firms have less scope to increase productivity in this way. As I have already explained, the output gap has closed, and as the economy is likely to continue expanding at a pace above its potential through fiscal 2007, the output gap is likely to become positive and then to widen moderately. Moreover, in a situation of improving labor market conditions and with labor shortages being observed in a relatively wide range of industries, wages are likely to continue rising moderately. The rise in wages and the slowdown in the growth in productivity will together put upward pressure on unit labor costs (labor costs per unit of output). Through fiscal 2007, unit labor costs are likely to show smaller declines, and to start increasing slightly at some point. One of the factors holding back upward pressures on prices during the economic recovery phase has been declining unit labor costs. As the effect of this factor diminishes, prices will be more inclined to rise than before. As for the year-on-year rate of change in the consumer price index (CPI; excluding fresh food), which has been positive since November 2005, we estimate that this will gradually rise to around the middle of the range between zero and 1 percent in fiscal 2006 and to slightly below 1 percent in fiscal 2007. III. Upside and downside risks to the outlook for economic activity In the above sections, I have outlined the core elements of the most likely projection for economic activity and prices. However, the economy constantly faces various risks and it should be noted that, should particular risks materialize, economic activity and prices may deviate from this projection. As downside risks to the outlook for economic activity, the April 2006 Outlook Report raises the following factors: slowdown in the growth of the world economy; and inventory adjustments, for example, in IT-related sectors. As for the first risk factor, developments in crude oil prices, which have been rising, and their impact on the world economy warrant attention. In relation to this, there is also a risk of a change in the situation where stable financial conditions are durable and inflationary pressures generally subdued which has been supporting the ongoing global economic expansion. With regard to the second factor, it should be borne in mind that inventory adjustments may be triggered as the economic recovery matures. Even if inventory adjustment occurs, it is unlikely that inventory adjustment carried out in some industries would seriously affect overall economic activity, since Japanese firms as a whole have completed adjustments in various excesses and their profitability has been recovering. As an upside risk to the outlook for economic activity, there is a possibility of further acceleration of business fixed investment. If firms accelerate investment, there may be a positive impact on overall growth. On the other hand, such acceleration may lead to an excessive build-up of the capital stock relative to the level of expected growth in demand, which may precipitate an economic slowdown via adjustments. Given that the output gap has already closed, if economic activity accelerates further and as a result the positive output gap widens rapidly, this will increase the risk of a subsequent compensatory correction. However, large economic swings can be avoided, thereby realizing sustainable economic expansion, if firms' investment stance does not become too aggressive. On this point, firms so far continue to increase business fixed investment based on favorable projections for sales and profits. However, overall, the value of fixed investment is being kept within the amount of firms' cash flow, and this suggests that they remain relatively cautious about accelerating fixed investment. The outlook for economic activity described earlier assumes that firms will maintain this cautious stance regarding investment. However, the current conditions point to further acceleration in investment by firms. Looking at corporate finances, firms' risk-taking capacity has increased as a result of the reduction of their debt excesses and the strengthening of their capital bases. Levels of return on assets are comparable to those recorded during the bubble era of the late 1980s. Since interest rates are extremely low, this favorable financial environment is likely to stimulate firms' investment. A turnaround in land prices in major metropolitan areas and a rise in stock prices may also accelerate firms' investment partly through increases in household spending boosted by the wealth effect. If firms were to further accelerate investment in this situation, overall economic growth would increase for a while, although this would generate the risk of a subsequent correction. IV. Upside and downside risks to the outlook for prices The following are considered to be key upside and downside risks to the outlook for prices: the path of international commodity prices including crude oil prices; and the degree of sensitivity of the rate of increase in the CPI to economic developments, that is, changes in the output gap. The April outlook does not assume that the rate of increase in the CPI will accelerate noticeably even when the output gap becomes positive, i.e., actual output exceeds potential output. This takes account of the weaker sensitivity of the rate of increase in the CPI to changes in the output gap, which is a tendency that has been observed in recent years not only in Japan but also worldwide. This is because prices of goods and services as well as wages have been under downward pressure due to industrialization of emerging economies as well as to firms in industrial countries shifting production facilities to overseas locations. Upward pressure on overall prices seems to have been restrained by increased productivity and intense competition both as a result of deregulation and advances in information and telecommunication technology. Additionally, in Japan unit labor costs have been able to fall considerably due to the relatively low rate of resource utilization. However, unit labor costs are expected to start increasing. Furthermore, as the output gap becomes positive, the sensitivity of prices to changes in economic activity may increase at some point, reflecting changes in firms' price-setting stance and higher inflationary expectations among the public, and thus prices may increase faster than anticipated. V. The impact of an increase in the potential growth rate I have thus far outlined the Bank's outlook for economic activity and prices for the next two years. I will next explain in more detail a point touched on in the projection described earlier, namely, the impact of the change in the potential growth rate on the Bank's conduct of monetary policy. The potential growth rate seems to have been increasing recently, as a result of firms' efforts in reducing excesses in production capacity and employment and their reallocation of capital and labor to areas likely to generate higher profitability and growth in demand. The Bank estimates that the potential growth rate has recovered to the 1.5-2 percent range recently, from its previous estimate of approximately 1 percent. When considering the impact of a rise in the potential growth rate on the conduct of monetary policy, the important point is to assess how such a rise affects aggregate supply and demand and hence prices. On the supply side, an increase in the potential growth rate gives rise to downward pressure on prices. More concretely, a rise in the potential growth rate acts to increase the supply capacity of the economy and thus exerts downward pressure on prices. Furthermore, since a rise in the potential growth rate tends to be accompanied by an increase in productivity, downward pressure may also be exerted on prices by the decrease in unit labor costs that can occur if wage rises lag behind the increase in productivity. On the demand side, however, a rise in the potential growth rate acts to boost aggregate demand. Therefore, a rise in the potential growth rate does not necessarily exert downward pressure on prices. The recent rise in the potential growth rate stems from firms' efforts to reallocate their resources to areas likely to generate higher profitability and growth in demand, and this implies an improvement in the overall economy's ability not only to produce goods but also to increase profits and income by selling those goods. Such real economic improvements brighten firms' and households' expectations regarding future income, and this brighter outlook, together with the wealth effect stemming from the rise in stock prices, is likely to stimulate aggregate demand by bolstering their spending. Moreover, since the expected rate of return on investment increases when the potential growth rate is rising, monetary easing effects become stronger at any given level of the real interest rate. The result is to further increase investment demand, triggering upward pressure on prices. In terms of the time frame, a rise in the potential growth rate often causes an increase in production capacity in the relatively short term, while in the longer term it seems to bring about an increase in demand and to strengthen monetary easing effects. Such a picture, however, is inevitably attended by uncertainty, since individual economic agents may increase demand in advance, taking account of increases in their expected future income and in response to the wealth effect. Whatever the case, a rise in the potential growth rate warrants close attention as it may give an expansionary push to the economy not only from the supply side but also from the demand side, and because its effect on prices can be both upward and downward. VI. Conduct of monetary policy I would now like to talk about the Bank's conduct of monetary policy, based on the outlook for economic activity and prices. At the Monetary Policy Meeting held on March 8 and 9, 2006, the Bank decided to terminate the quantitative easing policy, which had been maintained during the five years since March 2001. It decided to change the operating target of money market operations from the outstanding balance of current accounts at the Bank to the uncollateralized overnight call rate. The new target for the uncollateralized overnight call rate was set at effectively zero percent. Under the new guideline for money market operations, the volume of short-term funds-supplying operations by the Bank has been decreasing. Accordingly, the outstanding balance of current accounts at the Bank has now declined to around 16 trillion yen. So far, the short-term money market remains stable and there is gradually more activity being seen in the interbank market. The Bank will continue to closely monitor conditions in the short-term money market in reducing the outstanding balance of current accounts at the Bank. As long as the short-term money market remains stable, the reduction in the outstanding balance will be completed in line with the projection the Bank made when it terminated the quantitative easing policy in March. However, completing the reduction of the outstanding balance of current accounts at the Bank and raising the target interest rate, which is effectively zero percent, are two different issues. While the reduction in the outstanding balance of current accounts at the Bank is carried out taking full account of conditions in the short-term money market, the level of the target interest rate is to be set based on the Bank's assessment of economic activity and price developments. With regard to the future conduct of monetary policy based on the new operating target of money market operations, namely, the uncollateralized overnight call rate, the Bank introduced a new framework. The Bank announced that, under this framework, it would assess economic activity and prices from two perspectives, taking account of the "understanding of medium- to long-term price stability," which is expressed as an approximate range between zero and 2 percent in terms of the rate of year-on-year change in the CPI. In light of this assessment, it would outline and release its current view on monetary policy. The April Outlook Report was compiled under the new framework. In the Outlook Report, the Bank examined, from the first perspective, whether the outlook deemed most likely by the Bank for economic activity and prices two years into the future is that the economy will follow a path of sustainable growth under price stability. The Bank judged that Japan's economy is likely to achieve sustainable growth under price stability as long as the economy develops in line with the outlook described earlier. From the second perspective, the Bank examined the risks that are most relevant to conducting monetary policy, looking over a longer time horizon. As a result, the Bank came to the conclusion that, as an upside risk, it should pay attention in the medium to long term to larger economic swings, resulting in large fluctuations in the rate of inflation, mainly due to acceleration of business fixed investment reflecting the accommodative financial conditions. As for downside risks, the Bank examined the possibility of economic activity and the rate of inflation deviating downward from its projection due to various factors. The Bank's judgment was that even if economic activity is less robust and the inflation rate lower than expected, the risk of the economy falling into a vicious circle of declining prices and deteriorating economic activity has become smaller, since the Japanese financial system has regained stability and the economy has now cast off excesses in production capacity, employment, and debt. With regard to the future course of monetary policy, based on the assessment of economic activity and prices from the two perspectives, it seems probable that the accommodative financial conditions ensuing from very low interest rates will be maintained for some time following a period in which the uncollateralized overnight call rate is at effectively zero percent. Through and beyond this stage, the Bank will adjust the level of the target interest rate gradually in the light of developments in economic activity and prices. The Bank will continue to support the economy so as to achieve sustainable growth under price stability through the appropriate conduct of monetary policy.
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Opening speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the 13th International Conference hosted by the Institute for Monetary and Economic Studies, Bank of Japan, Tokyo, 1 June 2006.
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Toshihiko Fukui: Financial markets and the real economy in a low Interest rate environment Opening speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the 13th International Conference hosted by the Institute for Monetary and Economic Studies, Bank of Japan, Tokyo, 1 June 2006. * 1. * * Introduction Good morning, ladies and gentlemen. I am very pleased to address the 13th international conference hosted by the Institute for Monetary and Economic Studies. On behalf of my colleagues at the Bank of Japan, I welcome all the participants from all over the world. 2. Theme of this year's conference The theme of this year's conference is "Financial Markets and the Real Economy in a Low Interest Rate Environment." I am sure that this theme is timely for all of us, considering the financial and real economic conditions we have faced since the 1990s. Let me elaborate on this point, focusing on Japan's experience with quantitative easing. 3. Japan's experience with quantitative easing Since the 1990s, Japanese firms and banks have continued their adjustment efforts. Specifically, Japanese firms have tackled the so-called "three excesses," that is, the excesses of debt, employment, and production capacity, since the bursting of the economic bubble in the early 1990s. Japanese banks suffered from a massive non-performing loan problem, which plagued the stability of the financial system. In addition, around 2000, the collapse of the so-called IT bubble around the globe placed Japan's economy once more in a recessionary phase. In these circumstances, the economy faced the risk of falling into a deflationary spiral. Once the economy falls into such a vicious spiral, it is very hard to get out of it, since expectations of continuing deflation can be self-reinforcing. To prevent the vicious spiral, the Bank acted decisively by introducing the quantitative easing policy. The quantitative easing policy had two pillars: (1) provision of ample liquidity by the Bank with the adoption of the outstanding balance of current accounts at the Bank as the operating target for money market operations; and (2) a commitment by the Bank to continue to provide ample liquidity "until the consumer price index (CPI, excluding fresh food) registers stably a zero percent or an increase year on year." This policy package exerted significant influences on the overall interest rate environment. Specifically, the provision of ample liquidity drove the uncollateralized overnight call rate, which should reflect credit risks of borrower financial institutions, lower to 0.001 percent under the quantitative easing. In addition, the commitment to continue zero interest rates substantially flattened the yield curve. The strong effects of the quantitative easing policy on financial markets are very clear if we compare them with the U.S. situation in the 1930s. During the 1930s, although the U.S. Treasury bill rate declined to approximately zero percent, the federal funds rate, the rate at which financial institutions lend and borrow short-term funds, declined only to 0.25 percent. Moreover, the yields on government bonds have been much lower in Japan from the mid-1990s onward than they were in the United States of the 1930s. Thus, we can infer that the quantitative easing policy was one of the most decisive policy challenges for central banks from a historical perspective. In retrospect, Japan's economy finally started recovering in January 2002 after the strenuous efforts by firms and banks to resolve their problems that I have mentioned. As an aside, it was on March 20, 2003 that I assumed the office of Governor. At that time, the fact that Japan's economy had already started recovering was beyond my widest dreams. In my inaugural address, I mentioned that Japan's economy was still on shaky ground. Subsequently, the Bank stepped up the quantitative easing further by increasing the current account balances at the Bank far above the required reserves, as well as abiding by the CPI commitment. Also, in October 2003, the Bank provided a more detailed description of the commitment to maintain the quantitative easing policy from the perspective of enhancing the transparency of monetary policy. During this, we always kept in mind that we should carefully nurture the budding economic recovery. The quantitative easing policy showed visible effects on two fronts. First, the policy, particularly through the ample liquidity provision, stabilized the financial system, at a time when there were strong concerns over its stability. The ample liquidity the Bank supplied met the surges in financial institutions' liquidity demand, and thus successfully avoided a repetition of the large-scale credit crunch that was observed in 1997 and 1998. Second, the quantitative easing policy created and maintained a very accommodative environment that supported the recovery of Japanese firms, through the commitment to continue zero interest rates. In particular, bank lending rates and interest rates on corporate bonds continued to decline as a result of the flattening of the yield curve, as well as the gradual decline in credit risk premiums. Various potential transmission channels of the quantitative easing were discussed among economists at the time the Bank introduced the policy. One of these channels is the portfolio rebalance channel: as the proportion of safe assets such as the current account balances at the Bank increases in the asset portfolios of financial institutions, they are expected to adjust their portfolios, typically by increasing holdings of riskier assets such as loans. Looking back on the period under the quantitative easing policy, we are not yet sure whether this channel actually worked or not. The accommodative environment contributed finally to putting the economy back onto a solid recovery path. The year-on-year rate of change in the core CPI rose to the surface in October 2005 and turned positive the following month. Under these circumstances, the Bank decided to terminate the quantitative easing policy in March 2006. More specifically, the Bank decided to change the operating target for money market operations from the outstanding balance of current accounts at the Bank to the uncollateralized overnight call rate. Under the new scheme, the Bank currently encourages the uncollateralized overnight call rate to remain at effectively zero percent. During the period of the adjustment process, Japanese firms have been innovating continuously to strengthen their competitiveness. They have also expanded the global supply-chain network with a particular emphasis on developing their strategic linkages with Asian counterparts. Meanwhile, the Japanese banks have overcome the non-performing loan problem and are currently better positioned to respond to the demands for sophisticated financial services of the times. Such revitalization of both firms and banks should improve the efficiency of the market mechanism, thereby enabling a better allocation of resources. 4. Several questions to be discussed In what follows, let me raise several questions that I hope are discussed at this conference. First, how have financial markets functioned in the historically low interest rate environment? Have any unexpected effects of the low interest rate policy been detected in the financial markets? Second, has the interaction between financial markets and the real economy changed in a low interest rate environment? For instance, have the roles played by financial markets and asset prices in the transmission mechanism of monetary policy changed? Third, what are the consequences of a prolonged low interest rate environment? In particular, does the low interest rate policy pose potential risks to both financial markets and the real economy? Fourth, how can we evaluate the recent low interest rate policy from historical and international perspectives? For instance, can we derive policy implications by comparing our recent policy experiences with the past episodes of combating deflation such as the 1930s in the United States? 5. Final words There are no easy answers to these questions. During the next two days, I am looking forward to learning from both prominent scholars in this field and central bankers their analyses and perspectives on the "Financial Markets and the Real Economy in a Low Interest Rate Environment." I also hope the insights gained at the conference will be of some help to the future generations of central bankers. It would be our utmost pleasure if every one of you could obtain some insights from the discussions that follow. Thank you.
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Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, to the Japan National Press Club, Tokyo, 20 June 2006.
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Toshihiko Fukui: Recent economic and financial developments and the conduct of monetary policy Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, to the Japan National Press Club, Tokyo, 20 June 2006. * * * Introduction Japan's economy continues to grow, with domestic and external demand and also the corporate and household sectors well in balance. The economy is likely to achieve sustainable growth under price stability. Today, I will explain the background of the economic outlook and assess several risk factors influencing the outlook. Moreover, based on the review, I will talk about how the Bank will conduct monetary policy with a view to achieving sustainable growth under price stability. I. Outlook for economic activity and prices I will first summarize the outlook for economic activity and prices. The Bank presented the projection of economic activity and prices for two years ahead through fiscal 2007 in its Outlook for Economic Activity and Prices (hereafter the Outlook Report) released on April 28, 2006: Japan's economy is likely to experience a sustained period of expansion, with domestic and external demand and also the corporate and household sectors well in balance, and the year-on-year rate of increase in the consumer price index (CPI; excluding fresh food, on a nationwide basis) is likely to rise gradually. The Outlook Report pointed to the following four factors as the mechanism behind the projection. First, exports are likely to continue to increase reflecting global economic expansion. Second, corporate performance is likely to continue to be strong. Third, the positive influence of corporate sector strength on the household sector is likely to become stronger. And fourth, financial conditions are likely to remain extremely accommodative. Examining data available after the publication of the Outlook Report, developments in economic activity and prices so far seem to be in line with the projection in the Outlook Report. As for economic activity in fiscal 2005, which is the basis of the projection for fiscal 2006 and 2007, it was confirmed that the economy had continued to grow with balanced external demand and domestic demand particularly in the private sector. Real GDP registered an annualized growth rate of 3.1 percent for the January-March quarter of 2006 and 3.2 percent for fiscal 2005. Corporate performance continued to be strong, as is evident from increases in profits both in the manufacturing and nonmanufacturing sectors at the book closing for fiscal 2005, following the large gains in the previous fiscal year. In this situation, business fixed investment both in the manufacturing and nonmanufacturing sectors showed robust growth during the January-March quarter of 2006, as shown in the quarterly Financial Statements Statistics of Corporations by Industry. As for future developments in economic activity, the corporate sector is likely to remain strong. Major firms are expected to enjoy continued profit growth in fiscal 2006, which in the manufacturing sector is likely to be particularly strong in the processing industries, such as electrical machinery, general machinery, and automobiles, and in the nonmanufacturing sector in industries related to private consumption, such as retailing and services. Various surveys indicate that firms' business fixed investment plans are also relatively strong. We expect that the strength in the corporate sector will continue, but the growth in business fixed investment will gradually slow. I will elaborate on this later. The positive influence of the strength in the corporate sector on the household sector is becoming more evident. As for employment and wages, labor market conditions have been improving on the whole. The unemployment rate has recently declined to around 4 percent from the 5-6 percent level in 2003, and the ratio of job offers to applicants has been exceeding 1.00 for the first time since 1992. In addition to the increase in the number of part-time workers, the number of full-time workers has been increasing recently due to the shortage of labor felt among firms. As for wages, regular payments have started to rise in addition to the increases in overtime and bonus payments. Although the pace of increase in wages is moderate partly due to firms' efforts to restrain labor costs, the increase is likely to continue. With the increase not only in temporary income but also in the more permanent part of income, private consumption is likely to remain strong. Turning to prices, domestic corporate goods prices are rising, due to the surge in the prices of international commodities such as crude oil and nonferrous metals. Recently released statistics show that the year-on-year rate of increase in domestic corporate goods prices was 3.3 percent in May, faster than the 2.5 percent increase in April. It is likely to remain high for the time being. The year-on-year rate of increase in the CPI was 0.5 percent in April and continued to be on an uptrend. Looking at individual prices for items in the CPI basket, the number of items showing price rises is gradually increasing, and the trend toward price increases is becoming more robust. For example, prices for services, such as those for package tours, golf fees, and educational costs, have been revised upward with the start of the new fiscal year. Services prices are important indicators to confirm the general trend in prices, because their movements are largely influenced by changes in wages. Prices of items other than services, such as personal effects and clothing, are also increasing gradually. II. Developments in overseas economies As I explained, Japan's economy is likely to achieve sustainable growth under price stability. Domestic private demand seems to be standing on a firm foundation given that structural adjustment pressures in the corporate sector and the financial system have dissipated. This directs our attention to developments in overseas economies as one major risk factor determining the outlook for Japan's economy. In the U.S. economy, business fixed investment and production have been increasing steadily, but signs of deceleration in housing construction have finally been observed and the pace of increase in household spending and employment has been slowing. This trend suggests that interest rate raises by the Federal Reserve to date have been gradually taking effect. The increase in the core CPI has been accelerating slightly, reflecting the rise in utilization of labor and production capacity in addition to high crude oil prices. In this situation, inflationary concerns seem to be mounting. As for developments in the near future, important issues are whether economic deceleration in the United States will result in a soft landing, and whether inflationary concerns will be contained. In Europe, the momentum for economic recovery has been increasing gradually, as is evident from increases in exports and production and the recovery in household spending. Under these circumstances, the European Central Bank has been carefully raising its policy interest rate since 2005 in order to stave off the upward pressure on general prices from high crude oil prices and to sustain the economic expansion. The Chinese economy has continued to show extremely high growth. Monetary policy has been tightened recently so as to deal with the expansion in the money stock and bank lending as well as high growth in business fixed investment. Whether overheating of economic activity can be contained through appropriate policy conduct is an important factor when monitoring developments not only in the Chinese economy but also the world economy, and global price developments including developments in international commodity prices. In 2005, the world economy grew by nearly 5 percent. This expansion has been supported by the fact that a stable financial environment has been maintained by containing upward pressure on prices. A key factor in maintaining a stable financial environment is whether global inflationary concerns continue to be contained in the future. III. Developments in financial markets I would next like to briefly touch on recent developments in global financial markets. Stock prices have been declining in emerging economies as well as in major industrial countries. Financial markets in many emerging economies have been weak, as is evident from the falls in bond prices and foreign exchange rates in addition to stock prices. Prices of some international commodities, including those of nonferrous metals, have declined recently, after exhibiting large increases. Market participants point to various factors behind these developments. One is the adjustment of stock and commodity prices, which had risen substantially in the prolonged accommodative financial environment around the world, in response to changes in the degree of this financial accommodation. Another factor is uncertainty as to whether inflationary risks will be contained, and whether a considerable deceleration of economic activity will be staved off even when inflationary risks are contained. The fundamentals of economies worldwide, including Japan's, do not seem to have changed significantly so far. Under the current economic circumstances, financial markets are evolving in pursuit of a new equilibrium by digesting new information while interacting with each other. Financial market developments continue to warrant careful monitoring, since they influence economic activity through their impact on business and household sentiment. IV. Developments in inventory investment As I mentioned earlier, domestic private demand is standing on a firm foundation, but in the corporate sector, it is necessary to pay attention to the possibility of a stock adjustment. Such adjustment involves both downside and upside risks to the outlook for economic activity in the short term: inventory adjustment, for example in IT-related sectors, is a downside risk while a further acceleration of business fixed investment is an upside risk. Given that the output gap has already closed, a further acceleration of business fixed investment should be regarded not only as an upside risk in the short term but also a factor leading to larger economic swings in the longer term as a result of a subsequent downturn. Looking first at inventory investment, levels of inventories are still relatively low. The inventory cycle in the manufacturing sector as a whole suggests that the growth in shipments and inventories is more or less in balance. Focusing on individual industries, excess inventories, particularly of general-purpose products, had built up in the iron and steel, and chemical industries, but recently, adjustments in these industries have been coming to an end. In IT-related sectors, the level of inventories has been somewhat high, but this is basically in line with the increase in shipments, and thus unintended and excessive inventories have not been built up at the moment. There are some factors, however, that may trigger inventory adjustments. For example, although the demand for IT-related goods is expected to continue increasing, there is a possibility of inventory adjustments for such goods occurring depending on developments in demand. This is because the supply of these goods is increasing at a rapid pace, including in the high-value-added products sector where Japanese firms have a competitive edge. V. Developments in business fixed investment As mentioned earlier, a further acceleration in business fixed investment, as another possible avenue of stock adjustments, entails not only an upside risk in the short term but also a factor leading to larger economic swings in the longer term as a result of a subsequent downturn. From a business-cycle point of view, the economic recovery appears to be reaching the mature stage and growth is projected to gradually decelerate to the potential growth rate. Although corporate performance is likely to remain strong, the growth in business fixed investment is expected to slow as the level of capital stock becomes higher with the accumulation of past investment. As a result, the driving force of economic activity will shift gradually from the corporate sector to the household sector. The deceleration in business fixed investment is expected to stave off a build-up of capital stock and contribute to achieving a sustained period of growth. Especially given that the output gap has closed, excessive investment and stronger economic growth are likely to increase the risk of an eventual swingback. So far, no signs of excessive investment have been observed. In the face of intense global competition, firms seem to be selective in allocating their business resources. It is true, however, that the financial environment is extremely accommodative and gives incentives to firms to accelerate business fixed investment. Real short-term interest rates in Japan are currently negative and extremely low compared with real GDP growth currently exceeding 3 percent and an estimated growth rate of the potential output ranging from 1.5 to 2.0 percent. Moreover, the functioning of the financial system has been enhanced and private financial institutions have been maintaining a proactive lending posture. The year-on-year growth in lending by private banks turned positive in the summer of 2005 and has been on a gradual upward trend since. VI. Conduct of monetary policy in a low-inflation environment Turning to a slightly theoretical issue, until recently, the main difficulty in conducting monetary policy in a low-inflation environment has been focused on how to deal with the risk of a deflationary spiral. In a low-inflation environment, nominal interest rates are typically low and are thus more probable to be constrained by the zero bound. Because nominal interest rates cannot be lowered below zero, real interest rates are likely to become higher than the optimal level for the economy when prices fall. That increases the risk of the economy falling into a vicious cycle of declining prices and deteriorating economic activity. In Japan, such a risk has been a matter of strong concern since the end of the 1990s. At present, this risk has become low, since the Japanese financial system has restored its stability and firms have now resolved excesses in production capacity, employment, and debt. On the other hand, when economic activity is picking up as a result of an unprecedented monetary easing against severe economic conditions with low inflation, a central bank is required to carry out monetary policy adroitly to adjust monetary accommodation by assessing upside risks. For example, since the inflation rate tends to exhibit strong inertia, even if the supply-demand conditions in the economy become tighter, the observed rate of inflation and inflation expectations are likely to remain anchored at a low level. In such a situation, maintaining an excessively accommodative monetary condition entails a risk of causing temporary overheating of the economy and a subsequent downturn, thereby resulting in larger swings in economic activity. The sensitivity of the rate of inflation to changes in the output gap has tended to become weaker not only in Japan but also abroad in recent years, reflecting structural changes such as deregulation, advances in information and telecommunication technology, and the deepening of economic globalization. Since prices are becoming less sensitive in the short term, central banks are required to take appropriate measures by examining medium- to long-term risks to the economy. This suggests the need to take a forward-looking approach in the conduct of monetary policy. VII. A stable economic and price environment A stable economic and price environment, once achieved by the appropriate conduct of monetary policy with a view to medium- to long-term risks, allows firms and households to make decisions more smoothly. As a result, the allocation of resources in the economy as a whole will be more efficient, and not only will short-term economic fluctuations be reduced but also the medium- to long-term growth path will be pushed up. Looking back at real GDP trends in Japan and the United States over the past 25 years or so, we see that economies often achieve higher growth when they move in a less volatile manner. As a result of smooth economic adjustments in the early 1980s after the Second Oil Crisis, Japan's economy followed a higher trend growth path than the U.S. economy while it moved in a less volatile manner thereafter. This situation, however, was reversed after the bursting of the asset price bubble in the early 1990s, and Japan's economy experienced a decline in the trend growth path while moving in a volatile manner. Japan's economy is now emerging from the prolonged stagnation that was an aftermath of the bursting of the asset price bubble, and is heading toward a sustainable growth path under price stability. In order to ensure this development, it is important, through the appropriate conduct of monetary policy, to minimize the volatility of business cycles and maintain a stable economic environment. VIII. Conduct of monetary policy Before concluding my speech today, I will talk about the Bank's conduct of monetary policy based on the assessment of economic activity and prices mentioned so far. The Bank has been reducing the outstanding balance of current accounts at the Bank by paying due attention to the stability of the money market under the guideline for money market operations that encourages the uncollateralized overnight call rate to remain at effectively zero percent. Through this process, the uncollateralized overnight call rate has been stable at around zero percent, despite small temporary increases. In the call market, interest rates have shown some fluctuations reflecting market conditions and the volume of transactions has been gradually increasing. Under these circumstances, the Bank no longer finds it difficult to control the uncollateralized overnight call rate in its day-to-day operations. In this sense, the reduction of the outstanding balance of current accounts has virtually been completed. With regard to the future course of monetary policy, the Bank will conduct monetary policy in line with the thinking described in the Outlook Report as long as developments in economic activity and prices follow the Bank's projection presented also in the Outlook Report. In other words, it seems probable that the accommodative financial conditions ensuing from very low interest rates will be maintained for some time following a period in which the uncollateralized overnight call rate is at effectively zero percent. Through and beyond this stage, the Bank will adjust the level of interest rates gradually in the light of developments in economic activity and prices. The timing of a policy change depends on developments in economic activity and prices from this time on, and there is no predetermined view regarding the future path of monetary policy at this point. The projection in the Outlook Report, which appears to be the desirable course of the economy, that is, sustainable growth under price stability, is based on the assumption that market participants and firms have been factoring in future policy changes to some extent when making their decisions. If the economy develops in line with the projection, changing the policy interest rate in the light of developments in economic activity and prices will stave off an excess of economic activity, minimize the volatility of business cycles, and lead the economy onto a sustainable growth path. The projection suggests that economic activity is likely to slow and prices are expected to follow a moderate uptrend. Consequently, the Bank will not have to drastically adjust the policy interest rate, but, as mentioned earlier, will be able to adjust interest rates "gradually." Of course, there is the time lag before a monetary policy action influences economic activity and prices, and it is therefore necessary to not only take the current economic and price situation into account but also look ahead to future developments. In addition, in assessing developments in economic activity and prices, it is important to pay close attention to a variety of indicators and other relevant information in order to carefully judge overall conditions of economic activity and prices rather than concentrate on just one particular indicator, such as the CPI during the period of quantitative easing. Conclusion In sum, Japan's economy continues to grow, with domestic and external demand and also the corporate and household sectors well in balance. The Bank is determined to contribute to leading Japan's economy to sustainable growth under price stability, through the appropriate conduct of monetary policy.
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Excerpts of a speech by Mr Kazumasa Iwata, Deputy Governor of the Bank of Japan, at a meeting with business leaders, Akita, 8 June 2006.
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Kazumasa Iwata: The conduct of monetary policy under the new framework Excerpts of a speech by Mr Kazumasa Iwata, Deputy Governor of the Bank of Japan, at a meeting with business leaders, Akita, 8 June 2006. * * * The conduct of monetary policy The Bank of Japan terminated the quantitative easing policy in early March 2006, and is in the process of reducing the outstanding balance of current accounts held by financial institutions at the Bank. The outstanding balance, which was at around 30 to 35 trillion yen at the time of the termination, is currently at around 12 trillion yen. Some market participants take the view that the pace of reduction may be too fast, and speculate that this may reflect the Bank's intention to raise the target for interest rates at an early date. Market participants expect the Bank to raise the target for interest rates at some point during fiscal 2006, and this expectation has been factored into current market rates. The Bank, however, noted when the quantitative easing policy was terminated that it would take a few months before the outstanding balance declined to a level near the reserve requirement. The Bank's money market operations have been in line with this policy statement, and the Bank has not been accelerating the pace of reduction in order to raise the target for interest rates at an early date. It has been some time since money market transactions were conducted under normal market conditions, so that some rates have risen due to trading friction. Nevertheless, on the whole the Bank's reduction of the outstanding balance has been carried out in a stable manner. New framework of monetary policy and policy implementation The conduct of monetary policy is now based on the new framework announced in March this year and on the findings from examining the risks affecting the economic outlook that are described in the Outlook for Economic Activity and Prices (hereafter the Outlook Report). Under the quantitative easing policy, monetary policy was conducted with an emphasis on the underlying trend of the core consumer price index (CPI). To be more specific, with the overnight call rate at virtually zero percent, the Bank made a commitment to maintain the quantitative easing policy until the year-on-year rate of change in the core CPI registered zero percent or higher on a sustainable basis in order to affect market expectations of the future path of interest rates. 1 This effect is referred to as the policy duration effect. The effectiveness of the quantitative easing policy has been the focus of much debate and criticism. I believe, however, that ultimately the policy achieved its initial aims, although this took some time. There are two reasons for this success. First, the commitment by the Bank to maintain the quantitative easing policy until the core CPI registered zero percent or higher on a sustainable basis provided an anchor for stabilizing expectations concerning future price movements. Second, the commitment to maintain the policy helped keep relatively long-term rates as well as shortterm rates at low levels by affecting expectations regarding the future path of interest rates. As a result, the burden of firms' debt was lightened, facilitating business restructuring. This restructuring increased the effectiveness of resource allocation, leading to improvements in productivity and corporate profitability, and ultimately pushed up the potential growth rate. In short, the combination of low market interest rates and the increased rate of return on corporate nonfinancial assets acted as The significance of modern monetary policy is more in its ability to influence market participants' expectations of future policy interest rates than in the effects of changes in the policy rate itself. Mervyn King, Governor of the Bank of England, has referred to this phenomenon, in which the effectiveness of monetary policy is enhanced by movements in market interest rates that considerably exceed those in policy rates, as the "Maradona theory of interest rates." The name derives from Argentine football legend Diego Maradona who, in the 1986 World Cup match against England, ran 60 yards in a straight line before placing the ball in the English goal. Maradona was able to run straight for the goal because the English defenders were expecting sudden darting feints. For more details, see M. King (2005), "Monetary Policy: Practice Ahead of Theory," Mais Lecture 2005. the basic mechanism pushing the rate of change in the core CPI above zero percent. 2 It goes without saying that the Bank's ample provision of liquidity played a complementary role in stabilizing financial markets and keeping interest rates low. The quantitative easing policy was at times criticized as being extremely risky, being likened to driving with one's eyes on the rearview mirror because the Bank relied on a price index, a lagging indicator, in conducting monetary policy. The Bank did not rely solely on the rearview mirror, however. In October 2003, the Bank provided a detailed description of its commitment to maintaining the quantitative easing policy. One of the conditions underpinning the commitment was that the Bank needed to be convinced that the prospective core CPI would not once again drop below zero percent after terminating the policy. Following the introduction of a new framework in March, the Bank disclosed the Policy Board members' understanding of what constitutes "medium- to long-term price stability" in numerical terms. The distribution ranged between the rate of year-on-year change in the CPI of zero and 2 percent, with most members' median figures falling around 1 percent. It is important to note here that the "understanding of medium- to long-term price stability" was not kept within the Policy Board but was disclosed to market participants and made common knowledge. In this way, the information could become a focal point of market interest and function as a catalyst in forming a consensus concerning inflation expectations. 3 With the change in the framework, the policy anchor for price stability shifted from the commitment in terms of policy duration to the Policy Board's "understanding of medium- to long-term price stability." Furthermore, in light of the "understanding of medium- to long-term price stability," the Bank decided to examine periodically the risks facing the Japanese economy, both in the short term (one to two years) and in the medium to long term, using the findings to formulate its thinking on the future conduct of monetary policy. The Bank is thus able to implement short-term policy in a flexible and timely manner based on due assessment of economic risks. Returning to the metaphor of driving a car, the degree of divergence in the opinions of Policy Board members regarding the destination has been made clear (increased transparency), and the Bank is back to conventional driving with a close eye on the risks ahead, ready to react quickly when necessary. The new framework can be said to ensure transparency as well as timeliness and flexibility in two senses. First, disclosing the Bank's thinking concerning medium- to long-term price stability has enhanced the transparency of its policy conduct, making it possible to conduct short-term monetary policy with increased flexibility. Second, given the fact that Japan's economy is in transition away from deflation and that structural changes continue to take place in the economy, a review of the Policy Board's "understanding of medium- to long-term price stability," to be conducted once a year as a rule, will enable a more flexible response to changes in the economic outlook and ensure the transparency and flexibility of the Bank's monetary policy. In short, the new framework has articulated specific measures for realizing the principle of monetary policy stipulated in Article 2 of the Bank of Japan Law: to contribute "to the sound development of the national economy" "through the pursuit of price stability." Twentieth century Swedish economist Knut Wicksell developed the theory that when the actual market rate of interest exceeds the natural rate of interest (the rate at which the supply and demand for real capital are in equilibrium) deflation accelerates, while inflation accelerates when the opposite occurs. Two game theorists who were awarded the 2005 Nobel Prize in Economic Sciences emphasized the possibility that common knowledge could generate consensus building. This is because common knowledge, by becoming a focal point for people's interest, has the potential to alter their behavior. For more details, see K. Iwata and M. Fukao (1995), "Keizai Seido no Kokusaiteki Chosei (International Adjustment of Economic Systems)," Nihon Keizai Shimbun, Inc.; T. Schelling (1960), "The Strategy of Conflicts," Harvard University Press; and R. Aumann (1976), "Agreeing to Disagree," Annals of Statistics, 4. The key point here is that by stabilizing inflation expectations in the medium to long run, flexibility in conducting monetary policy in the short run has been increased, and this in turn has made it easier to achieve the objective of sustainable growth under price stability. The "understanding of medium- to long-term price stability" is different from the Bank of England's inflation target or the European Central Bank's quantitative definition of price stability, and is an important first step toward the optimal monetary policy for realizing the principle stipulated in Article 2 of the Bank of Japan Law. The policy interest rate – the basis for producing forecasts In the most recent Outlook Report, the economic forecasts of Policy Board members were made taking account of market participants' expectations of future policy rates, which were deduced from market interest rates. 4 Under the quantitative easing policy, it was natural to base forecasts on the assumption that the policy interest rate would be constant until at least the year-on-year rate of change in the core CPI registered zero percent or higher on a sustainable basis. Under the current framework, however, this assumption would be rather unnatural. Prices of assets, such as stocks and land, incorporate expected future movements in interest rates. Therefore, the assumption of constant interest rates would generate a forecast based on asset prices that differ from those currently observed. It goes without saying that ignoring actual asset prices when making forecasts is highly counterintuitive. This does not of course imply that Policy Board members base their economic forecasts directly on the market's forecast of the policy interest rate. Mechanically adopting market forecasts of interest rate developments in conducting monetary policy and preparing forecasts might cause economic and price developments to diverge from the Bank's desired path. The new method does, however, take into account market expectations in making economic forecasts, and thus its adoption is another important step toward achieving an optimal monetary policy. Conclusion Against a background of high crude oil prices, major countries around the world are in the process of economic adjustment, aiming for a soft landing near the potential growth rate while maintaining stable prices. Financial markets around the world also are making adjustments, reflecting changes in the economy as they seek a new equilibrium. The Japanese economy has so far been moving in line with the forecast described in the April Outlook Report. Although various risks lie ahead, Japan's economy is likely to achieve sustainable growth under price stability. I believe, however, that in order to make this happen, it is vital that monetary policy is implemented appropriately so that the full potential of the new policy framework can be realized. In making forecasts, assumptions about the policy interest rate fall into three classes. In the first, a constant interest rate path is assumed. In the second, the interest rate path is assumed to be in line with market expectations. And in the third, interest rates are assumed to follow the optimal path projected by the central bank based on the information available to it. The Bank of England carries out forecasts using the first two approaches. The third approach is adopted by the central banks of New Zealand and Norway. For more details on Norway, see J. F. Qvigstad (2005), "When Does an Interest Rate Path 'Look Good'? Criteria for an Appropriate Future Interest Rate Path."
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Statement by Mr Toshihiko Fukui, Governor of the Bank of Japan, concerning the Bank's Semiannual Report on Currency and Monetary Control, before the Committee on Financial Affairs, House of Representatives, Tokyo, 16 June 2006.
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Toshihiko Fukui: Semiannual report on currency and monetary control Statement by Mr Toshihiko Fukui, Governor of the Bank of Japan, concerning the Bank's Semiannual Report on Currency and Monetary Control, before the Committee on Financial Affairs, House of Representatives, Tokyo, 16 June 2006. * * * Introduction The Bank of Japan submitted its Semiannual Report on Currency and Monetary Control for the second half of fiscal 2005 to the Diet on June 9, 2006. I am pleased to have this opportunity to present an overall review of the Bank's conduct of monetary policy. I. Developments in Japan's economy Japan's economy continues to recover steadily. Exports and industrial production have continued to increase. Business fixed investment has continued to increase against the background of high corporate profits. This strong corporate performance is benefiting the household sector. The number of employees has been increasing steadily in a situation where firms were more aware of the shortage of labor, and wages have also been rising gradually as a trend. As a result, household income has continued rising moderately. With this steady improvement in the employment and income situation, private consumption has been on an increasing trend. Looking forward, exports are expected to continue rising against the background of further expansion of overseas economies. Domestic private demand is likely to continue increasing against the background of high corporate profits and the moderate rise in household income. Japan's economy is likely to experience a sustained period of expansion, with domestic and external demand and also the corporate and household sectors well in balance in an environment in which a virtuous cycle of production, income, and expenditure will operate. There are various risks concerning future developments in Japan's economy. For example, prices of international commodities such as crude oil have remained at high levels. In this situation, whether the world economy, especially the U.S. economy, can maintain sustainable growth while containing inflationary risks warrants attention. On the price front, domestic corporate goods prices have continued to increase, mainly reflecting the rise in international commodity prices, and are expected to keep increasing for the time being. The year-on-year rate of change in the consumer price index (CPI; excluding fresh food, on a nationwide basis) turned slightly positive in November 2005 and has been posting relatively clear increases since January 2006. The conditions of persistent excess supply have been dispersed, and the output gap currently seems to be close to zero. The year-on-year rate of change in the CPI is projected to continue to follow a positive trend, as the output gap is likely to gradually become positive. As for the financial environment, the environment for corporate finance continues to be accommodative. The rate of increase in the amount outstanding of lending by private banks is accelerating in a situation where private banks have been maintaining a proactive lending posture and the decline in credit demand in the private sector has come to a halt. In the corporate bond and CP markets, the issuing environment continues to be favorable. Large fluctuations have recently been observed globally in financial markets. The Bank will closely monitor developments in financial markets and their effects on economic activity. II. Conduct of monetary policy As I explained in my statement to this Committee in March 2006 concerning the Bank's previous Semiannual Report on Currency and Monetary Control, the Bank terminated the quantitative easing policy and shifted the operating target of money market operations from the outstanding balance of current accounts at the Bank to the uncollateralized overnight call rate at the Monetary Policy Meeting (MPM) held on March 8 and 9, 2006. Since then the Bank has been maintaining the guideline for money market operations that the Bank will encourage the uncollateralized overnight call rate to remain at effectively zero percent, and at the MPM held on June 14 and 15, decided to maintain this guideline. The Bank has been reducing the outstanding balance of current accounts based on the guideline, paying due attention to the stability of the money market. Through this process, the uncollateralized overnight call rate has been stable at around zero percent, despite small temporary increases. In the call market, the volume of transactions has been gradually increasing. The Bank has explained its basic thinking regarding the future conduct of monetary policy together with the projection for economic activity and prices in the Outlook for Economic Activity and Prices published at the end of April 2006 as follows. As long as Japan's economy experiences a sustained period of expansion, with domestic and external demand and also the corporate and household sectors well in balance, it seems probable that the accommodative financial conditions ensuing from very low interest rates will be maintained for some time following a period in which the uncollateralized overnight call rate is at effectively zero percent. Through and beyond this stage, the Bank will adjust the level of interest rates gradually in the light of developments in economic activity and prices. The timing of a policy change and the level of interest rates will depend on developments in economic activity and prices from this time on, and there is no predetermined view regarding the future path of monetary policy at this point. The Bank is determined to conduct monetary policy appropriately in the light of developments in economic activity and prices, and contribute to sustainable economic growth with price stability.
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Speech by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, at the Yomiuri International Economic Society, Tokyo, 21 July 2006.
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Toshiro Muto: Recent conduct of Japanese monetary policy Speech by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, at the Yomiuri International Economic Society, Tokyo, 21 July 2006. * * * Introduction At the Monetary Policy Meeting (MPM) held on July 13 and 14, 2006, the Bank of Japan changed the guideline for money market operations and decided to keep the uncollateralized overnight call rate at around 0.25 percent. This was the first policy change since March this year when we abandoned the quantitative easing policy and announced the "Introduction of a New Framework for the Conduct of Monetary Policy." This action demonstrates that the Bank has returned to pursuing a monetary policy in which it controls interest rates both in name and in deed. Today, I would like to explain the background to the policy change and, by picking up on some key issues, discuss in detail the framework of interest rate control and how its effects feed through into the economy. I. The current state and outlook for the Japanese economy A. Sustained economic recovery The Bank publishes its economic outlook that covers a period of about one year and a half to two years in its semiannual Outlook for Economic Activity and Prices (hereafter the Outlook Report). In the April 2006 Outlook Report, we presented our view that, through fiscal 2007, the Japanese economy is likely to experience a sustained period of expansion under price stability. Economic developments since then seem to indicate that the economy is moving broadly in line with this projection. The expansion of overseas economies is broadening in extent. In the United States, the pace of economic expansion has moderated somewhat, reflecting recent decreases in housing investment and slowing growth in household expenditure and employment. These developments, however, can be seen as part of the process of adjustment toward stable growth. In Europe, the momentum for economic recovery is picking up gradually, as exports and production are growing and household expenditure has also firmed. In China and other newly industrialized countries in East Asia, strong economic expansion is continuing on the back of further progress in the international division of the production process, in terms of both scale and quality, as a result of economic globalization. Against this background of overseas economic expansion, Japan's exports are increasing at a steady pace. Turning to developments in domestic demand, business fixed investment is showing steady growth. According to the June Tankan (Short-Term Economic Survey of Enterprises in Japan), corporate profits have increased for the fourth consecutive year since fiscal 2002 and, taken as a whole, are expected to continue to increase in fiscal 2006, although the influence of higher raw material prices is being observed in some sections of materials industries. Given the increase in corporate profits, business fixed investment plans for fiscal 2006 are displaying high growth, matching the growth recorded in fiscal 2005. This steady growth in business fixed investment is attributable not only to growth in demand at home and abroad and high levels of corporate profits, but also to the dispelling of excess liabilities and a rise in the capital utilization ratio, as well as the increasing obsolescence of existing capital equipment. The positive effects of favorable corporate profits are being passed through to the household sector. Looking at the employment and income situation, the ratio of job offers to applicants is being maintained somewhat above 1.00, and the unemployment rate has come down to 4.0 percent. Household income remains on a gradual increasing trend, while related indicators suggest that labor market conditions are tightening. Households' expectations regarding the employment and income situation have been gradually revised upward, and as a result consumer sentiment is generally positive. Some considerable fluctuation has been observed in financial markets since mid-May, as evidenced by the decline in stock prices. Such declines have been seen not only in Japan but in other major as well as emerging economies, making it a global phenomenon. The adjustment in stock prices may reflect a reevaluation of risk profiles by market participants, as central banks have adjusted the degree of their monetary easing in response to economic and price developments. Also pointed out is growing uncertainty as to whether the world economy, including the United States, will be able to realize steady growth while maintaining a grip on inflation. The swings in financial markets, however, do not seem to imply any significant change in the economic fundamentals underpinning the world economy, which is likely to continue expanding. Nevertheless, we intend to keep a close eye on developments in financial markets and their influence on economic activity, including the economic impact of recently increased geopolitical risks. B. Changes in price conditions With the economy experiencing sustained growth, conditions surrounding prices have also improved. The current phase of economic recovery has already lasted for over four years, and if continued through October, it will match the Izanagi boom - to date the longest phase of economic expansion in the postwar era. As a result of this sustained recovery, the estimated "output gap," that is, the difference between actual aggregate demand and the economy's potential supply capacity, is now registering a situation of excess demand. According to the June Tankan, the perception among firms of having excess production capacity has dissipated for the first time in some ten years. As for the employment situation, not only is the labor market as a whole less slack but some shortages are becoming apparent, reflecting an improved overall balance between demand and supply. With the output gap pointing to an excess of aggregate demand over supply, wages are on a moderate upward trend and are expected to rise further in the future. So far, unit labor costs, that is, labor costs required to produce one unit of product, have been dropping substantially on the back of decreasing wages. The result has been a situation in which even when the output gap contracts and excess supply diminishes, this does not feed through into increased prices. Although the growth in productivity is expected to continue putting downward pressure on prices, the decline in unit labor costs is likely to narrow since wages are increasing moderately, and this will eventually lead to a moderate rise in prices. Given this change in price conditions, various surveys indicate that firms and households are revising their forecasts for prices upward. According to the Bank's Opinion Survey on the General Public's Views and Behavior, which asks households to give specific numbers to reflect their expectations of future price conditions, the average of the expected inflation rate for the next five years has increased to 2 percent from around 1 percent in previous surveys. With respect to price indices, domestic corporate goods prices recorded a year-on-year increase of 3.3 percent in May and June, reflecting higher crude oil and other international commodity prices. This rate of increase surpasses that in early 1990, when the consumption tax was raised, and is the highest recorded since early 1981. The year-on-year rate of change in the consumer price index (CPI; nationwide basis, excluding fresh food) has also been positive since the end of last year, and in the figure for May, the latest available, posted a 0.6 percent increase. Although this reflects the rise in petroleum product prices, the degree to which this factor has been contributing has not increased. Rather, the prices of a growing number of items other than petroleum products are rising, as evidenced in the upward revision seen in some services prices, a phenomenon often observed at the turn of the fiscal year. It is these broader price rises which can be identified as the main factor behind the upward trend in the CPI. The year-on-year rate of change in the CPI is expected to stay positive, as the output gap continues to register excess demand. Although the year-on-year rate of change in the CPI is likely to be revised somewhat downward due to the rebasing of the index in August, the current assessment of a positive rate of price change is unlikely to be affected. C. Interim assessment of the outlook for economic activity and prices At the MPM held on July 13 and 14, we examined the current condition of the economy and prices and conducted a midterm review of the outlook for economic activity and prices through fiscal 2007, with a view to assessing whether economic and price conditions are likely to follow the path stated in the Outlook Report. As a result of this examination, we concluded that economic developments are likely to be broadly in line with the outlook described in the Outlook Report. As for prices, the year-on-year rate of change in domestic corporate goods prices in fiscal 2006 is likely to be higher than projected in the Outlook Report, reflecting the rise in prices of crude oil and other international commodities, but in fiscal 2007 the year-on-year rate of change is likely be around the level predicted in the Outlook Report. The rate of change in the CPI (nationwide basis, excluding fresh food) is expected to stay within the range given in the outlook through fiscal 2007. II. The aim of the Bank's policy change in July A. Examination from two perspectives Let me now describe the aim of the recent policy change in light of the outlook for economic activity and prices. In March 2006, the Bank introduced the "New Framework for the Conduct of Monetary Policy." At that time, we stated our intention to review economic and price conditions from two perspectives when making decisions on monetary policy. The first perspective involves examining whether the outlook deemed most likely for the economy and prices over the next one to two years is consistent with a path of sustainable growth under price stability. Then, in the second perspective, we examine various risks relevant to the conduct of monetary policy over the longer term, and consider how these may impact on our aim of realizing sustainable growth with price stability. In terms of the first perspective, Japan's economy is likely to achieve sustainable growth with price stability. However, as I will discuss later, such an outlook presumes that market participants and firms have, to some extent, factored future changes in monetary policy into their managerial decisions. For the economy to develop in line with the projection in the Outlook Report, therefore, some adjustments in the level of the policy interest rate seem necessary. Turning to the second perspective, although no risks of emerging excesses, such as in business fixed investment, have been detected to date, it should be noted that the stimulative impact of the current easy monetary policy is gaining strength along with the steady improvement in economic conditions. Should this impact strengthen further, we may well observe the economic growth rate temporarily deviating significantly above our projection due to accelerated business fixed investment, given that the slack in the economy has already been taken up. In such a case, excess buildup of capital stock may eventually require economic adjustments. In the long run, this would lead to unwarranted fluctuations in economic activity and increase the risk of a large swing in prices. We also need to carefully watch other risk factors affecting economic activity, such as higher crude oil prices, and their possible consequences for overseas economies. The risk of Japan's economy falling back into a vicious cycle of deflation and deteriorating economic activity, however, seems smaller than before given the return of stability and confidence in the financial system and the dispelling of excesses in the corporate sector, namely, in capital stock, labor holdings, and levels of debt. In the late 1990s, after the bubble era, Japan's economy experienced two recovery phases, which were derailed by external shocks. The recessions that followed were deep. In hindsight, the depth of these recessions could well have been aggravated by excess holdings of capital stock, labor, and debt in the corporate sector as well as the fragility of the financial system - the other side of the same coin - all of which exert downward pressure on the economy. During the current recovery phase, however, economic recession has not occurred, although temporary losses of recovery momentum have been seen. In the summer of 2004, for example, adjustments in IT-related industries caused the economy to enter a soft patch which lasted for nearly a year. Eventually, however, the economy regained its recovery momentum. Such incidents suggest that the current recovery phase is quite different from its predecessors in the 1990s, exhibiting greater durability in the face of shocks. B. Change in the guideline for monetary market operations At the MPM held on July 13 and 14, the Bank decided to change the guideline for its money market operations in the intermeeting period to "encourage the uncollateralized overnight call rate to remain at around 0.25 percent." We judged, after examining the economic and price situation from the two perspectives outlined above, that an adjustment in the interest rate level was appropriate in order to keep the economy on a desirable path. Such a change, in our view, will contribute to ensuring price stability and achieving sustainable economic growth in the medium to long term. This policy change was made on the basis of an economic and price forecast, which remained unchanged from the April Outlook Report, and in line with the basic thinking governing the conduct of monetary policy stated in it. We will continue to conduct monetary policy based on the careful examination of economic and price conditions. More specifically, if the economy is likely to follow the path projected in the Outlook Report, then this will entail some gradual adjustment in the level of the policy interest rate so as to accommodate the ongoing changes in economic and price conditions. Such being the case, it is likely that an easy monetary environment with extremely low interest rates will be maintained for some time. The Bank's basic thinking in this regard has been emphasized repeatedly, but simply put, we intend to adjust the level of interest rates gradually, taking careful account of developments in economic activity and prices. In line with the policy change, we have decided to raise the basic loan rate offered under the complementary lending facility to 0.4 percent. The interest rate differential between the basic loan rate and the operating target of the uncollateralized overnight call rate has widened marginally from the previous 0.10 percent to 0.15 percent. Generally speaking, the smaller this differential, the less likely the uncollateralized call rate is to diverge from the Bank's operating target. At the same time, however, a smaller differential is also likely, to some extent, to restrict the free formation of market interest rates. Recently, the situation in the money market has been somewhat restrictive from the standpoint of the free formation of interest rates: a consistently large amount of lending has been taking place through the complementary lending facility, mainly reflecting high repo rates. On the other hand, the functioning of the money market, which has been in the process of recovery since the abandonment of the quantitative easing policy in March, has not yet been fully restored, so that some smoothing of the fluctuations in the call rate was still deemed to be necessary. On balance, therefore, we decided to keep the changes to the interest rate differential between the basic loan rate and the operating target of the uncollateralized overnight call rate as small as possible because we thought that, while also giving consideration to the principle of the free formation of interest rates, our priority should be to control the call rate in a stable manner. III. Interest rate control and its transmission A. Control of short-term rates As stated above, our current guideline for money market operations is to "encourage the uncollateralized overnight call rate to remain at around 0.25 percent." Under the framework of the quantitative easing policy in place until March this year, our main operating target was a "quantity," namely, the outstanding balance of current accounts that financial institutions hold at the Bank. For example, the guideline for money market operations set forth at the MPM in February this year was to "conduct money market operations, aiming at the outstanding balance of current accounts held at the Bank at around 30 to 35 trillion yen." At central banks in leading industrial nations, monetary policy is conducted by controlling money market interest rates at the very short end. It is also quite common for these central banks to set a target for such money market rates or to set the base rate for their money market operations as the "policy interest rate," thereby leading the money market to achieve the target or the base rate. Since the abandonment of the quantitative easing policy in March this year, the uncollateralized overnight call rate, which is a rate used in trading overnight funds among financial institutions, has been the Bank's operating target for its money market operations. In other words, after a lapse of five years, implementation of monetary policy at the Bank of Japan has finally come back into line with that of other central banks in leading economies. B. The money market and interest rate arbitrage In connection with the Bank's return to an interest rate policy, let me take the opportunity to discuss, over a rather longer-term perspective, the framework of interest rate control and the mechanisms by which it is transmitted. The Bank conducts money market operations as a participant in the market. While the bond and stock markets serve as venues for trading long-term funds or capital, the money market is characterized by the trade for short-term funds. Money markets are normally defined as markets where funds with maturities of less than a year are traded. They are sometimes classified according to the nature of their participants: the interbank market is so called because its participants are limited to financial institutions, while the open market's participants also include firms and local governments. The call market is an interbank market where short-term funds are traded among financial institutions so as to clear their daily excesses or shortages of funds. The call market is further subdivided into the uncollateralized and collateralized call markets, according to the collateral requirements for trading. Examples of open markets include the bond gensaki market, the repo market (for the lending/borrowing of Japanese government securities against cash collateral), the certificate of deposit (CD) market, the commercial paper (CP) market, the treasury bill (TB) market, and the financing bill (FB) market. The Bank controls interest rates by conducting daily money market operations where it buys and sells financial instruments such as bonds through competitive auctions, thereby adjusting for excesses or shortages of funds in the money market that may arise, for example, from changes in the supply of banknotes and public funds. The interest rate assigned as the target in such an operation is the uncollateralized overnight call rate. The Bank's conduct of monetary policy begins with this exertion of control over the uncollateralized overnight call rate, and this is then conveyed through interest rate arbitrage to other rates in the money and bond markets as well as on deposits and loans, thus eventually coming to affect economic activity as a whole. C. How the change in the money market interest rate is conveyed to medium- to longterm interest rates The mechanism by which a very short-term market interest rate, such as the uncollateralized overnight call rate, is transmitted through to interest rates at the longer end of the market is based on the idea that medium- to long-term interest rates are constructed as an average of expected short-term interest rates during the period concerned, plus a risk premium covering uncertainty. The implication is that while the central bank tends to determine a very short-term interest rate in accordance with the economic and price situation, medium- to long-term interest rates are determined by market participants' expectations concerning the future evolution of economic activity and prices, the central bank's monetary policy response to these developments, and the appropriate size of the risk premium given the level of uncertainty in the economy. Medium- to long-term interest rates determined in this way reflect market projections of the future path of short-term interest rates. Monetary policy does not directly control the yield curve, a curved line that indicates the relationship between interest rates and maturities; rather, the yield curve is shaped by the term structure of interest rates, which incorporates market participants' expectations regarding the central bank's future policy decisions. Ultimately, it is the shape of the yield curve that actually influences the economic decisions of firms and households. It is important to control the anticipated path of the short-term interest rate, but this does not mean that the Bank can always keep medium- to long-term interest rates low by setting the path of short-term interest rates low and by communicating this to market participants. This is because, in the long run, the future path of the policy interest rate needs to be in line with the economic and price situation. If a policy interest rate is continuously set too high or too low relative to economic and price conditions, this will have an adverse impact on the economy and prices, which will eventually require a significant rise or reduction in the policy interest rate by the central bank. If market anticipation of such unnecessary fluctuations in interest rates increases uncertainty, the risk premium will become larger, thereby causing medium- and long-term interest rates to shift further upward. It is sometimes said that long-term interest rates reflect people's view of future economic and price conditions, and they cannot therefore be controlled by monetary policy. Long-term interest rates are in fact influenced by a change in monetary policy, but for the reasons outlined above, the central bank cannot force them out of line with underlying economic and price conditions. If monetary policy is conducted in line with economic and price conditions, and market participants are confident that this will be the case, the risk premium will become smaller, providing a firm basis for long-term interest rate stability. D. Influence on economic activity Let me now turn to the influence of a shift in the yield curve on economic activity. There are actually several routes by which this impact is felt. One route involves influencing investment activity by altering its profitability. As I have stated, the effects of changes in the policy interest rate are passed onto interest rates in various financial markets as well as deposit and loan rates. From the standpoint of firms and households, funding rates change in line with a change in the policy interest rate, and this will affect their decisions to invest in equipment and housing. Another possible route operates via changes in foreign exchange rates affecting either the profitability or the volume of exports. Changes in the domestic interest rate affect nominal foreign exchange rates through, for example, arbitrage between domestic and overseas interest rates. The resultant movements in nominal foreign exchange rates will alter competitiveness in export industries, thereby affecting either the profitability or the volume of exports. A third route operates via changes in asset prices influencing investment and consumption behavior. With the ongoing accumulation of financial assets in recent years, changes in equity and land prices are thought to have a greater impact on the spending behavior of firms and households. Finally, other routes such as changes in interest rate returns affecting corporate profits are also important. These routes describe how changes in the shape of the yield curve feed through into changes in economic activity. When economic agents such as firms and households make investment decisions, they naturally take into account potential risks. These risks vary with the investment horizon, which will be reflected in the maturity of the financial instruments selected to fund the investment. The further ahead firms and households are required to look into the future, the larger the influence of changes in medium- to long-term interest rates upon their investment decisions. Furthermore, since the market expectations concerning the future outlook for the economy and prices as well as the policy response of the central bank form the basis of medium- to long-term interest rates, these market expectations become particularly important. IV. Issues related to interest rate control A. The significance of the "official discount rate" So far, I have discussed the basic framework of interest rate control and its paths of transmission. I would now like to turn to some issues related to interest rate control. There are three key issues here: the significance of the "official discount rate," the importance of expectations formation, and the transmission lag following monetary policy actions. Let me start with the significance of the "official discount rate," which is the rate the Bank applies when lending directly to financial institutions. The "official discount rate" is probably one of the most familiar terms used in association with monetary policy. However, it is in fact not prescribed in the Bank of Japan Law. The term "official discount rate" was used to refer to two rates specified within the Bank of Japan Law, namely, the "basic discount rate" and the "basic loan rate." In the past, these rates were prescribed under two separate categories as the "Discount Rate of Commercial Bills and Interest Rates on Loans Secured by Government Bonds, Specially Designated Securities and Bills Corresponding to Commercial Bills" and the "Interest Rates on Loans Secured by Other Collateral," and they were set separately. In 2001, these two categories were combined into a single rate termed the "Basic Discount Rate and Basic Loan Rate." During the days of regulated interest rates, the "official discount rate" was the policy interest rate typically used to express the basic stance of monetary policy. In those days, various interest rates were linked to the "official discount rate" and changes in the "official discount rate" directly affected deposit and lending rates. A change in the "official discount rate" was considered to constitute a change in the basic stance of monetary policy and thus to have a so-called "announcement effect." In 1994, however, the liberalization of interest rates was completed and the systematic linkage between the "official discount rate" and deposit rates diminished. Currently, all interest rates are determined by arbitrage in the market, as I explained earlier, and not by systematic linkage. As a result, the role of "official discount rate" has shifted to the rate offered under the complementary lending facility - a loan facility, introduced in 2001, through which the Bank extends loans at the request of counterparties subject to conditions pre-specified by the Bank - and this now effectively stands as the de facto upper limit on the overnight call rate. Importantly, however, the current policy interest rate is the uncollateralized overnight call rate and not this "official discount rate." For this reason, we think it appropriate to use the term "basic loan rate" or "rate offered under the complementary lending facility" in preference to "official discount rate," which has tended in the past to be associated with the policy interest rate. B. The importance of expectations formation Let me now discuss the importance of expectations formation. I have just explained how economic agents' expectations concerning the future path of the policy interest rate influence economic activity and hence developments in prices. The implication is that the impact of monetary policy can be more effectively increased by influencing market expectations regarding future policy than by independently raising or lowering interest rates. If a change in shortterm interest rates is considered merely temporary, it will not alter the level of medium- or long-term interest rates, and its overall influence on the economy will be limited. On the other hand, if market participants form expectations that a change in short-term interest rates will be long-lasting, mediumto long-term interest rates will respond accordingly, thereby increasing the overall impact on the economy. When expectations are formed about future changes in short-term interest rates and these are fully incorporated in the formation of medium- to long-term interest rates, a number of points are relevant. First, the intended effect of a policy change is achieved as soon as it is anticipated, rather than at the point when it is actually enacted. If a fully anticipated future policy change is incorporated in the shape of the yield curve, firms and households will take the change as given and make their consumption and investment decisions accordingly. Second, medium- to long-term interest rates will not change substantially at the actual enactment of the policy change. The idea that a substantial policy impact can only be achieved if the policy takes the market by surprise and causes a sudden large shift in medium- to long-term interest rates is fundamentally flawed. If the policy change is fully incorporated in market expectations, it may seem as though its actual enactment by the central bank is merely following the market. However, this should be taken as evidence that monetary policy is being conducted credibly and transparently, with economic agents such as firms and households behaving accordingly. And third, even if a policy change has already been incorporated into market expectations and its effect achieved, this does not mean that it is no longer actually necessary to enact the change. Should the market expectations be disappointed, this will affect perceptions of future monetary policy, thereby changing the shape of the yield curve. Given the relationship between expectations formation and the yield curve described above, the central bank should seek to improve transparency by carefully explaining its assessment of the state of the economy and financial developments, and ensuring that the formation of the yield curve will be consistent with its thinking regarding the conduct of monetary policy by laying out the latter clearly. With this in mind, the Bank has been communicating with the public through the release of, for example, the Outlook Report, the Minutes of the MPMs, the Monthly Report of Recent Economic and Financial Developments, press conferences, and speeches, as well as by enriching the content of its web site. As a result, the Bank is now probably one of the heaviest suppliers of information among central banks. The point here is that ensuring the transparency of monetary policy is not just about accountability, but also about raising the effectiveness of monetary policy. Needless to say, central banks do not follow the market when the market expectation of a policy change is deemed erroneous. In such cases, the central bank will seek to adjust market expectations by communicating to the market its assessment of economic conditions and its views on the appropriate conduct of monetary policy. Bearing this in mind, it is useful to incorporate an expected future change in the policy interest rate and its anticipated influence on the economy into the outlook for economic activity and prices that the central bank makes public. In the past, the Bank's outlook for economic activity and prices was based on the assumption of a "fixed monetary policy," in other words, it hypothesized that its monetary policy would be unchanged. Since the April 2006 Outlook Report, however, the Bank's outlook for economic activity and prices has been produced taking account of forecasts of the future policy interest rate embodied in market interest rates, instead of assuming that the policy interest rate will remain unchanged. A number of other central banks that publish an economic and price outlook, such as the Bank of England (BOE) and the European Central Bank (ECB), have started to use market participants' projections of the policy interest rate as the assumed policy interest rate when producing their outlooks. C. Transmission lags Lastly, I would like to take up the issue of the so-called transmission lag, the time lag between a monetary policy action and its impact on the economy. It takes a certain amount of time for the effects of a monetary policy action to filter through into the economy and prices. Among the various transmission channels mentioned earlier, the effects of a change in interest rates on expected rates of return on investment may be felt within a relatively short period of time. Transmission through foreign exchange rates and asset prices may also take place swiftly. It takes time, however, for an interest rate change to affect household income through corporate profits. Considerably more time is then required for a change in corporate profits and household income to gradually alter firm and household sentiment and hence impact on consumption and investment decisions. For a policy change to be fully transmitted through to the economy, therefore, requires a considerable amount of time even when firms and households are rational and forward-looking. There are then still further lags between the change in the economic situation and the eventual impact on prices. It is such lags in policy transmission that necessitate a forward-looking approach to conducting monetary policy. For policy actions to be effective, it is necessary to act based on the outlook for economic activity and prices over a sufficiently long term. In the Quarterly Bulletin of the BOE, for example, the economic and price outlook of Monetary Policy Committee members for the next three years is produced and published. At the ECB, the staff release their outlook for the economy and prices over the next two years. Behind the time frames of these reports lies the idea that the transmission of monetary policy through to the economy takes place with a long lag. Furthermore, the length of the lag differs substantially not only depending on the structure of the economy but also depending on other factors such as the phase of the business cycle. For this reason, producing accurate economic and price projections that incorporate the transmission lag is no easy task. In recent several years, especially, productivity growth and wage restraint in the corporate sector have made prices less sensitive to economic recovery. The situation has, so far, contributed favorably to economic developments, in the sense that economic expansion has been relatively compatible with price stability. Viewed from a medium- to long-term perspective, however, the implication is that short-term projections of inflation will prove inadequate as guideposts for steering monetary policy toward price stability and that past relationships between economic conditions and prices will no longer hold. It is, therefore, becoming more important to act with appropriately increased sensitivity to risks affecting economic activity and prices over longer horizons. Concluding remarks I have so far explained the background to the recent change in the Bank's monetary policy and discussed in some depth issues related to interest rate control and the path by which its effects are transmitted to the economy. Let me raise one important point before I conclude. That is, for the effects of monetary policy to filter through into the economy in the way I have discussed today, both financial markets and financial institutions have an important intermediary role to play. Strengthening the monetary policy transmission mechanism by improving the functioning of various financial markets and financial institutions is also very important in supporting the infrastructure of a dynamic Japanese economy in the long run. In this regard, the Bank has been encouraging the fostering and growth of market transactions geared toward improving the functioning of the financial markets. Improving the practice of money market operations, the introduction of a next-generation real-time gross settlement system, and the improvement of business continuity plans in times of disaster are some examples. We, along with market participants, intend to strive to further improve the functioning of financial markets. As for enhancing financial institutions' performance of their intermediary functions, we will be working toward creating an environment where financial institutions, through discussions during on-site examinations or interviews, are able to build new business models and upgrade frameworks for risk control, as well as to improve management and internal control systems so as to allow monetary functions to operate efficiently. The Bank would like to contribute, through such efforts, to achieving sustainable economic growth in Japan under price stability. Thank you very much for your attention.
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bank of japan
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Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the Kisaragi-kai meeting, Tokyo, 7 November 2006.
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Toshihiko Fukui: The outlook for Japan's economy and the conduct of monetary policy Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the Kisaragi-kai meeting, Tokyo, 7 November 2006. * * * Introduction At the Monetary Policy Meetings at the end of April and October, the Policy Board of the Bank of Japan approves the text of the Outlook for Economic Activity and Prices, or the Outlook Report as we call it for short, and makes it public. Today, I would like to discuss the Bank's view on the current state of and outlook for the domestic economy and overseas economies as well as the Bank's thinking behind its conduct of monetary policy, with reference to the October 2006 Outlook Report, which was released last week. I. Developments in overseas economies Let me first touch upon recent developments in the global economy. In the United States, deceleration in the pace of economic expansion is becoming clearer, as seen, for example, in the decrease in housing investment. However, business fixed investment and production continue to increase, and the pace of deceleration in private consumption has been moderate so far. Meanwhile, in the euro area, the momentum of economic recovery is becoming more evident. The increases in production and the recovery in corporate profits observed so far have contributed to an improvement in the employment situation and increases in business fixed investment. In China, strong expansion in both domestic and external demand is continuing. The rate of growth in fixed asset investment remains high, although the pace of growth has been slowing slightly as a result of measures taken by the Chinese government and the People's Bank of China to contain the overheating of the economy. Oil-producing countries, such as those of the Middle East, continue to experience an economic boom supported partly by the significant improvement in the external balance resulting from the rises in crude oil prices. Other emerging economies also continue to expand. Thus, the global economy as a whole continues to expand strongly, with the slowing growth in the U.S. economy being offset by high growth in other economies. The global economy is expected to continue expanding steadily across a broader range of regions. According to the International Monetary Fund (IMF), the global economy has registered high growth rates of around 5 percent for two consecutive years: 5.3 percent in 2004 and 4.9 percent in 2005. The global economy is expected to continue expanding at around the same pace, at 5.1 percent in 2006 and 4.9 percent in 2007. This is the first time since the early 1970s that the global economy has registered and is expected to continue to register high growth of around 5 percent over a period of some years. Looking at the growth rates of individual countries, the developed economies have not necessarily been growing faster than in the past; rather, the countries contributing to the current high growth are the emerging economies that have taken off, one after another, as economic globalization progressed. These countries have increased their overall presence in the global economy and have contributed greatly to the high global growth rate. Asian emerging economies in particular have enjoyed high growth rates for many years, and their share in the global economy has increased so much that they have become an engine of global economic growth. This is evident from the IMF's latest projection of world economic growth, which was revised in September. Based on a substantial upward revision of the growth projection for Asian emerging economies, the projected growth rate of the world economy has been pushed up despite the downward revision of the growth projection for the U.S. economy. II. The current state of the Japanese economy I would now like to turn to the current state of the Japanese economy. The current phase of economic recovery began in January 2002. In November, it will have lasted for four years and ten months, exceeding the Izanagi boom, the longest postwar economic expansion (57 months during 1965-70). Looking at recent economic developments, exports have continued to increase against the background of the expansion of overseas economies, which I have just outlined. By destination, exports to the United States have maintained their steady growth as a whole, although growth in automobile-related goods has slowed somewhat. Exports to Europe and East Asia have continued their solid increases, and those to other regions, particularly the oil-producing countries, have registered high growth. Corporate profits have been high despite the surge in prices of raw materials such as crude oil. Large manufacturing firms in particular have made successive upward revisions to their profit estimates due to the increase in exports coupled with the depreciation of the yen. In this situation, business sentiment remains favorable and business fixed investment continues to increase. According to the September Tankan (Short-term Economic Survey of Enterprises in Japan) conducted by the Bank's Research and Statistics Department, if firms' business plans for fiscal 2006 are realized, current profits will register growth for the fifth consecutive year (since 2002), and business fixed investment will record an increase for the fourth consecutive year (since 2003). The current strong business fixed investment continues to be led by the manufacturing sector, although nonmanufacturers as well as small firms have started to step up their fixed investment. The acceleration in business fixed investment reflects the fact that firms are seeking to reinforce their capacity to supply goods and services by increasing capital equipment as they look to capture profit opportunities in overseas markets. In the 1990s, when Japan was undergoing severe adjustments after the bursting of the bubble economy, there was a view that the increasing supply capacity of emerging economies was a threat that would deprive Japanese workers of job opportunities. This view, however, is one-sided, and the rapid development of emerging economies has in fact been playing a significant role in establishing the foundation of Japan's economic development toward a new era. It is very beneficial to the development of Japan's economy that Japan and emerging economies - especially strongly growing Asian emerging economies - have established a new system of international division of the production process and interdependent relations in a constructive manner. For example, goods requiring a relatively high degree of processing, such as IT-related machinery, have been gradually increasing their share in Japan's imports from other Asian economies, replacing labor-intensive goods, such as clothing and other light manufactured goods. This is mainly because Japan's direct investment in other Asian economies has been increasing as Japanese firms optimize their production processes. As a result of the creation of production bases and employment opportunities with the increased direct investment, Asian economies have been increasing their presence in the global economy, not only as global suppliers but also as markets with high growth potential. Asian economies are becoming one of the driving forces of the ongoing expansion of the global economy, and this in turn is spurring Japan's exports. One of the notable characteristics of the current recovery phase of Japan's economy is that many Japanese firms continue to scrutinize investment profitability. They are not only increasing investment to boost production capacity but also accelerating the replacement of obsolete capital equipment to improve efficiency. Such corporate behavior can be interpreted as reflecting the fact that the management of firms, amid intensifying global competition and greater exposure to the discipline of the capital market, is becoming more attentive to increasing corporate value. The positive influence of the strength in the corporate sector has fed steadily through to the household sector, albeit at a moderate pace. Labor market conditions have been tightening as the ratio of job offers to applicants has increased and the unemployment rate has been on a downtrend. The number of employees has been increasing steadily, partly due to the recovery in the hiring of new graduates. Yet, even in this situation, wage increases have remained moderate so far. We believe that this is because, while employers continue to restrain labor costs, employees, having experienced a severe employment situation, continue to prefer stable employment to a wage increase. However, further tightening of labor market conditions seems inevitable if the number of employees continues to increase when growth in the labor force levels off. For example, wages of part-time and temporary workers have already started to increase and large firms are planning to increase significantly the number of employees, including regular employees. In this environment, the pattern of behavior of employers and employees is likely to change gradually, and upward pressure on wages, including regular payments, is expected to strengthen accordingly. Sales at department stores and supermarkets were relatively sluggish from spring to around July, partly due to the unfavorable weather conditions, but picked up in August and September. Sales of electrical appliances and outlays for services have continued to be favorable. Given that changes in regular payments are usually considered to constitute changes in permanent income, an increase in regular payments is likely to ensure a sustainable rise in private consumption, especially spending on durable goods and services. In sum, Japan's economy has been expanding moderately with a virtuous circle of production, income, and spending in operation. The current recovery has certainly been driven strongly by expansion in external demand, but it is not accurate to say that the recovery has been brought about by external demand alone. Against this background of the ongoing economic expansion, the environment surrounding prices has been gradually changing. First, the utilization of resources such as production capacity and labor has been rising. According to the Tankan, the perception among firms of having excess production capacity has dissipated for the first time in more than a decade. In terms of employment, firms are increasingly feeling a shortage of labor due to improving labor market conditions. An estimate of the output gap, which represents the difference between aggregate demand and potential aggregate output in the economy, suggests that the conditions of persistent excess supply have been dispersed and the output gap seems to have become positive. Second, wages are rising, albeit moderately, as labor market conditions are improving and firms are feeling a shortage of labor in a relatively wide range of industries. In contrast, unit labor costs, that is, the labor costs incurred to produce one unit of product, are still decreasing due to the increase in productivity, but the pace of decrease has clearly slowed, reflecting the moderate uptrend in wages. And third, as suggested by various survey results, inflation expectations of firms and households are shifting up. The September Tankan showed that an increasing number of firms in a wide range of industries answered that their output prices had risen compared with three months ago. Retailers are considered to have a strong influence on consumer prices, and the number of retailers expecting a rise in output prices exceeded the number expecting a fall. According to the most recent issue of the Opinion Survey on the General Public's Views and Behavior, which is conducted by the Bank's Public Relations Department and covers a nationwide sample of 4,000 individuals, about 60 percent of respondents felt that prices had risen from a year earlier, and about 80 percent of respondents expected prices to rise in the one-year period ahead. III. The Bank's outlook for economic activity and prices In the April Outlook Report, the Bank presented the projection that, from fiscal 2006 through fiscal 2007, Japan's economy was likely to experience a sustained period of expansion, with the positive influence of the strength in the corporate sector feeding through into the household sector and the corporate and household sectors well in balance. Comparing the recent developments in economic activity and prices to the April projection, developments in the corporate sector have been somewhat stronger, as evidenced in corporate profits and business fixed investment, while those in the household sector have been somewhat weaker, as evidenced in wages and private consumption. On the whole, however, economic developments have generally been in line with the April projection. Given these developments, the Bank, in the October Outlook Report, projected that economic developments in the near future are likely to follow in general the path projected in the April Outlook Report. That is, from the second half of fiscal 2006 through fiscal 2007, the economy is likely to experience a sustained period of expansion, with domestic and external demand increasing and the positive influence of the strength in the corporate sector feeding through into the household sector. As the economic expansion lengthens and matures, growth in business fixed investment is likely to moderate. As a result, the economic growth rate is likely to slow gradually from around 2.5 percent for fiscal 2006 to around 2 percent for fiscal 2007, approaching the potential growth rate. On the price front, the domestic corporate goods price index has been exceeding the April projection, mainly reflecting the rises in crude oil and other international commodity prices. The index is likely to continue to be on an uptrend, although the projection is subject to developments in crude oil and other commodity prices and foreign exchange rates. The year-on-year increase in the consumer price index (CPI; excluding fresh food, on a nationwide basis) is likely to gradually rise from the 0.0-0.5 percent range in fiscal 2006 to around 0.5 percent in fiscal 2007. The CPI was rebased in August 2006, with the base year being changed to 2005 from 2000, and yearon-year figures as far back as January 2006 were revised retroactively. Accordingly, the Bank used the 2005-base CPI in the October Outlook Report while it used the 2000-base CPI in the April Outlook Report. At the time of the April Outlook Report, the Bank estimated that the extent of the negative divergence caused by the rebasing was likely to be slightly less than 0.3 percentage point, approximately the same as that at the previous rebasing of the CPI from the 1995 base to the 2000 base. In fact, the negative divergence turned out to be greater, around 0.5 percentage point on average during January and July 2006, but this was due to the effects of changes in the calculation of indices for existing items in the CPI basket, such as mobile telephone charges. Since such effects disappear after the first year, the divergence is likely to be reduced. Thus, the basic view on the CPI in the current projection remains the same as that in the April projection, which used the 2000-base CPI, and the Bank's projection that the year-on-year increase in the CPI is likely to gradually rise continues to be valid as the Bank's main scenario. IV. Factors causing positive and negative deviations in economic activity Economic activity has so far been generally in line with the April projection. However, any kind of projection is subject to upside and downside risks. It should be noted that the following factors could cause positive and negative deviations from the baseline projection of economic activity. The first risk concerns the growth path of the global economy. The latest outlook is based on the following environment surrounding exports: although the pace of expansion in the U.S. economy has been decelerating recently, the economy is likely to realize a soft landing and to move toward sustainable growth; and overseas economies as a whole are likely to keep expanding across a broader range of regions. These views are generally comparable with the IMF's World Economic Outlook and forecasts by other international organizations and private research institutes. Global economic growth is likely to remain robust even with a modest slowdown in the U.S. economy, as the growth of emerging economies has increasingly become self-sustained. Recent developments in Japan's exports show that goods, particularly capital goods and automobiles, in which Japanese firms have a competitive edge, are being exported to an increasing number of countries. According to the September Tankan, firms perceived overseas demand for Japanese products as exceeding supply in the current period and continuing to do so in the future. This implies that at this point firms do not feel that the slowdown in U.S. economic growth will substantially affect overseas demand for Japanese products. However, if a greater-than-expected downward adjustment in housing prices occurs in the United States, it may lead to lower growth rates in the U.S. economy via, for example, a deceleration of growth in private consumption. If the pace of U.S. economic growth decelerates unexpectedly, adjustment pressure may build up in the IT-related sector. Global demand for IT-related goods has so far been on a steady uptrend due partly to the rapid growth in emerging economies, such as the BRIC economies (Brazil, Russia, India, and China). However, the pace of global increase in the supply of ITrelated goods has also been rapid, and thus if downside risks to the outlook of the U.S. economy materialize, the balance between supply and demand of IT-related goods may be disturbed. In addition, inflation expectations may rise, if the U.S. economy does not slow considerably in a situation where resource utilization, namely in production capacity and labor, is high. One of the factors supporting the sustained expansion of the global economy is the continuing stable financial conditions and generally subdued inflationary pressures due at least in part to the appropriate conduct of monetary policy in countries around the world. Any changes to the picture may adversely affect the global economy, and be accompanied by shifts in international capital flows and repricing in financial markets. With the fall in crude oil prices, it is becoming increasingly likely that inflation pressures in the United States will gradually ease as economic growth decelerates moderately. However, risks in the United States of a slowdown in economic growth or an acceleration in the inflation rate still require attention because if either occurs, the impact on the global economy will be large. In the euro area, the European Central Bank has been raising its policy interest rate amid appreciation of the euro, and the sustainability of economic recovery should be watched carefully. In Germany, fullscale fiscal consolidation has started; for example, the value-added tax rate will be raised from January 1, 2007, and such measures may place downward pressure on the economy in the short term. In China, the economy continues to expand strongly, and there is a possibility that this growth will accelerate during the projection period, influenced by developments in fixed asset investments and exports. Even though administrative measures will probably help to contain the rise in the growth rate of investment for some time, the risk of a further acceleration of the economy and subsequent repercussions cannot be ruled out, since the financial environment continues to be accommodative. Global economic developments may also be influenced by international commodity prices, such as crude oil prices, depending on their future movements. The second risk is a further acceleration of business fixed investment. Although firms, especially manufacturers, have been stepping up their business fixed investment, an excessive build-up of capital stock has not so far been observed in the economy overall. Since firms are very careful in choosing their investment projects, business fixed investment as a whole has, despite recent acceleration, generally been kept within cash flow and the pace of increase in capital stock is moderate. In evaluating whether the growth in capital stock is excessive or not, developments not only in the moderately growing domestic market but also in strongly growing overseas markets need to be taken into account. With the economy continuing to expand moderately, financial conditions remain extremely accommodative. Short-term interest rates have been very low relative to the state of economic activity and prices. The yen has been depreciating against other major currencies. The real effective exchange rate is currently as low as that recorded in the period immediately after the conclusion of the Plaza Accord in 1985. Given such extremely accommodative financial conditions, firms may further accelerate investment based on optimistic assumptions of future profitability, such as favorable expectations regarding the growth rate, financing costs, and foreign exchange rates. Such acceleration may push up overall growth in the short run, but may lead in turn to an excessive build-up of capital stock that could precipitate an economic slowdown. The upturn in land prices, particularly in major cities, is becoming more broad-based. Such a recovery in land prices basically indicates that people's view on future economic activity has improved and they are increasingly expecting higher returns from investment in real estate projects. There seems no need at present to be concerned about possible excessive rises in land prices, but a rise in asset prices is likely to push up private demand. V. Factors causing positive and negative deviations in prices Regarding the outlook for prices, attention needs to be paid to factors that may cause prices to deviate either upward or downward from the projection. Developments in the prices of crude oil and other commodities are an example of such factors. Another important factor is to what extent consumer prices will change in response to economic developments, especially changes in the output gap. Turning to the outlook for the CPI, the year-on-year rate of increase is expected to rise gradually, reflecting increasing upward pressure on wages and the moderate widening expected in the positive output gap. This outlook, however, assumes that the rate of increase in the CPI will not noticeably accelerate, since it takes into account the possibility that prices may be less sensitive to changes in the output gap than in the past. This decline in sensitivity is attributable to deregulation, advances in information and communication technology, the robust global economic growth, and economic globalization reflecting such growth. For example, if competition between domestic goods and imported goods from emerging economies intensifies, upward pressure on prices may be contained even when the domestic output gap turns positive. Likewise, if intensifying global competition is pushing firms to raise corporate value, upward pressure on prices may be contained as firms try to increase wage restraint despite tight labor market conditions and to raise productivity. The sensitivity of prices to changes in the output gap, however, may be subject to substantial variation as it differs depending on how it is influenced by deregulation, advances in information and communication technology, and economic globalization. If sensitivity to the output gap is not as weak as assumed, prices may rise more than expected. Similarly, even if prices are less sensitive to changes in the output gap in the short term, the rate of wage and price increases might accelerate at some point accompanied by an increase in inflation expectations. On the other hand, if the sensitivity of prices to the output gap is weaker than assumed, prices will not respond even if economic activity is stronger than expected. Our projection assumes that as the economic expansion lengthens, productivity increases will slow and wages will rise. However, if the pattern of employers' and employees' behavior that I mentioned - firms maintain their restraint on labor costs, while employees continue to prefer stable employment to a wage increase - persists for longer than expected and rises in wages lag behind, upward pressure on prices may continue to be contained. Changes in prices of international commodities, such as crude oil, also affect price developments. Crude oil prices had declined after posting a record high in the summer, but they are still at a high level. They may either surge or plunge in the future depending on, for example, developments in geopolitical risks. VI. Conduct of monetary policy I would now like to turn to the Bank's conduct of monetary policy, based on the outlook for economic activity and prices. In March 2006, when the quantitative monetary policy implemented in 2001 was terminated, the Bank introduced the "New Framework for the Conduct of Monetary Policy," with the aim of ensuring the transparency of monetary policy from a relatively long-term viewpoint. In line with the new framework, the Bank assesses economic activity and prices from two perspectives, taking account of the "understanding of medium- to long-term price stability," which is expressed as approximately 0 to 2 percent in terms of the year-on-year rate of change in the CPI, and outlines and makes public its view on the future course of monetary policy. The Bank's assessment from the first perspective, which is the outlook that it deems most likely for economic activity and prices through fiscal 2007, is that Japan's economy is likely to continue expanding with domestic and external demand increasing and that the year-on-year rate of increase in the CPI (excluding fresh food, on a nationwide basis) is expected to rise gradually through fiscal 2007, as the level of excess demand in the economy (the positive output gap) is increasing at a moderate pace and downward pressure from declining unit labor costs is weakening. In sum, Japan's economy is likely to achieve sustainable growth under price stability. This outlook is based on the assumption that market participants and firms have, to some extent, factored future changes in monetary policy into their decisions. Therefore, for economic activity and prices to develop in line with the above outlook, adjustment in the level of the policy interest rate seems necessary. The assessment from the second perspective - in which the Bank assesses the risks considered most relevant to conducting monetary policy, looking over a longer time horizon and taking account of the cost incurred should risks materialize, however improbable they might be - is that although at present there seem to be no signs of overinvestment, the stimulative effect of monetary policy on economic activity and prices may be amplified with corporate profitability high and prices on a positive trend. For instance, if the expectation takes hold that interest rates will remain low for a long time regardless of economic activity and prices, there is a risk in the medium to long term of larger economic swings, resulting in large fluctuations in the rate of inflation, channeled, for example, via financial behavior and investment activity. Meanwhile, depending on future developments, the economic expansion and rising prices may stall. However, Japan's economy seems more resilient to such shocks, since the financial system has regained stability and the economy has now cast off excesses in production capacity, employment, and debt. In fact, the economy recovered its momentum shortly after entering a soft patch due to adjustments in IT-related industries in the summer of 2004. Unlike in the past, the risk of the economy falling into a vicious circle of declining prices and deteriorating economic activity seems small, even if the economic expansion and rising prices stall. With regard to the future course of monetary policy, as a result of the assessment of economic activity and prices from the two perspectives, it seems appropriate to adjust the level of interest rates gradually in the light of developments in economic activity and prices, while maintaining the accommodative financial conditions ensuing from very low interest rates for some time. Such an adjustment in the policy interest rate, in our view, will contribute to ensuring price stability and achieving sustainable economic growth in the medium to long term. Should a large disturbance in the price and economic situation occur, a drastic policy change may become necessary, which would potentially carry the danger of causing large economic swings. In order to avoid this happening, it is important for the Bank to take a forward-looking approach in its conduct of monetary policy. Such forward-looking policy is not intended to stifle growth potential, but rather to steer the economy toward a sustained period of expansion. As I have emphasized repeatedly, the Bank does not have a predetermined view regarding a future increase in the policy interest rate. The Bank will adjust the level of interest rates gradually, carefully assessing economic activity and prices. Conclusion Under the new framework for the conduct of monetary policy, it is very important for the Bank to carefully explain its assessment of the state of the economy and financial developments and its thinking regarding the conduct of monetary policy. The Bank has been communicating with the public through, for example, the Outlook Report, the minutes of Monetary Policy Meetings, the Monthly Report of Recent Economic and Financial Developments, press conferences and speeches, and by enriching the content of its web site. In July this year when the Bank brought the zero interest rate environment to an end after five years, financial markets remained calm, a fact that has been lauded by overseas central banks and international organizations. The calm response of financial markets can be regarded as evidence that the Bank's message to market participants was well understood and the new framework for the conduct of monetary policy functioned effectively in communicating with market participants. Ensuring transparency with the new framework is important not only in terms of better communication with market participants, but also in terms of increasing the effectiveness of monetary policy. The Bank will continue to conduct monetary policy appropriately and to contribute to achieving sustainable economic growth under price stability.
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Summary of a speech by Mr Kazumasa Iwata, Deputy Governor of the Bank of Japan, at the Fourth ECB Central Banking Conference, "The role of money: money and monetary policy in the twenty-first century", Frankfurt am Main, 10 November 2006.
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Kazumasa Iwata: The role of money and monetary policy in Japan Summary of a speech by Mr Kazumasa Iwata, Deputy Governor of the Bank of Japan, at the Fourth ECB Central Banking Conference, “The role of money: money and monetary policy in the twenty-first century”, Frankfurt am Main, 10 November 2006. * * * Introduction The role of money in implementing monetary policy is one of the most controversial issues in Japan. Although the importance of the role of money in the transmission mechanism of monetary policy cannot be denied, there exists a wide divergence in views on the impact of changes in monetary aggregates on economic activity and prices among academics and policy makers. This is particularly true when faced of the zero bound on nominal interest rates in combating deflation. In evaluating the role of money, I would like to take up three episodes in post-war Japan; namely, the oil price hikes from the mid-1970s to early 1980s, the emergence and bursting of the asset price bubble from the mid-1980s to early 1990s, the experience of persistent deflation under the zero interest rate and the quantitative easing policy covering from the mid-1990s to March 2006. First episode: oil price hikes and the money supply-oriented monetary policy In the first episode, the rapid acceleration of money supply growth amid expansionary fiscal policy after 1971 induced rampant inflation. In spring of 1973, Japan moved to the flexible exchange rate system to mitigate the tradeoff between the free international capital flows and the control of the money supply. Yet, the first oil price hike in late 1973 exacerbated the already strong inflationary pressures. The Bank of Japan succeeded in overcoming the rampant inflation and its stagflationary impact arising from the two oil price hikes by monitoring the money supply (M2+CDs) carefully. After the mid-1970s, the money supply growth was held down steadily, while the volatility of money supply changes diminished significantly. Corresponding to the gradual deceleration of money supply growth, the inflation rate subsided remarkably (Chart 1). In 1982, Milton Friedman described Japan’s monetary policy in the 1970s as “less monetarist in rhetoric, yet far more monetarist in practice than the policies followed by the United States and Great Britain.” Despite the praise of Friedman, Japan’s money supply-oriented monetary policy cannot be regarded as “monetary targeting policy”. In 1975, the Bank of Japan employed monetary aggregates as one of the important information variables, yet it eschewed attaining the reference value of the monetary growth target (Bank of Japan (1975)). Instead, from 1978 the Bank of Japan began to announce a quarterly forecast for money supply growth, yet the forecast was different from the “intermediate target growth rate” announced by the Federal Reserve or the M3 reference target rate by the ECB. 1 The forecast was close to the actual outcome, yet money supply reaccelerated and diverted from the trend nominal GDP growth after the mid-1980s in the wake of financial deregulation and innovation. To conclude, the first episode reconfirms the lesson that the control of money supply (which was restored under the flexible exchange rate system) played an essential role in containing the rampant inflation prevailing in the early 1970s. Neuman (2003) justified the reference value of M3 growth rate by the ECB based on the link from core money to core inflation. Given the means of the range (4.5%) consisting of the potential growth rate (2-2.5%), normative rate of inflation (less than 2%) and the trend decline of velocity ranging from 0.5% to 1%, he detected the true normative rate of inflation to be equal to 1.5%. Second episode: asset price bubbles and the real money gap Let me turn to the second episode. Lax monetary policy after the mid-1980s was evidenced by the sustained deviation of actual real money stock from the equilibrium real money stock. Given the positive “real money gap”, asset price bubbles emerged in the equity and real estate markets while general price stability was maintained (Chart 2). 2 Once land prices started to move up, the augmented collateral value of land triggered the rapid expansion of bank credit through the “financial accelerator mechanism” or the “credit cycle” on the imperfect financial market. 3 On the other hand, price stability was reinforced by the yen appreciation after the Plaza Accord in 1985 in spite of the accelerating money supply. 4 Plentiful market liquidity facilitated the active management of risk portfolios through relaxing the liquidity constraint and affected the willingness of investors to take more risks, leading to the reduction in risk and term premia. From the second episode, we can draw the lesson that a positive “real money gap” can cause the asset price bubbles through the “financial accelerator mechanism” and the reduction in risk and term premia, precisely because price stability is maintained. Third episode: deflation and the quantitative easing policy Turning to the third episode, after the bubble burst in the early 1990s, the required adjustment to the balance sheets of both the corporate and banking sectors tended to significantly lower the natural interest rate and reduce the potential growth rate from about 5% to about 1% in the mid-1990s. 5 It is not difficult to gauge the consequence from the Wicksellian process perspective: deflation began to prevail as the natural interest rate became significantly lower than the real market interest rate. After the “zero interest rate policy” from February 1999 to August 2000, the “quantitative easing policy” was initiated in March 2001. The quantitative easing policy set bank reserves as an operating target and reconfirmed the commitment to continue the virtual zero interest rate policy until the core CPI growth rate stands above zero in a stable manner. 6 The perceived emergence of the “liquidity trap” under the zero short-term interest rate seemed to undermine the effectiveness of the quantity-oriented monetary policy, as the interest rate elasticity of demand for money became close to infinity at the zero short-term interest rate. 7 Moreover, the linkage between monetary aggregates and income or prices has largely disappeared since 1997, mainly reflecting the increase in precautionary demand for money due to financial instability and nonperforming assets on the banks’ balance sheets. 8 Gerlach and Svensson (2002) compared the usefulness of the “real money gap” (which can be decomposed into the “GDP gap” and the “velocity gap”) as an information variable with the GDP gap. They thus noted that the deviation of actual monetary growth from the “unconditional” monetary growth target is likely to be a misleading indicator of risks to the price stability because of the tradeoff between the price stability and monetary growth target stability: in their view the Bundesbank actually gave priority to price stability rather than monetary target stability when the tradeoff between the “unconditional” money growth target and the inflation target becomes serious. Kiyotaki and Moore (1997) developed the “credit cycle” theory, on the assumption of the financial constraint to borrow on the imperfect financial market. Regarding the emergence of the asset price bubble, the explanation based on the “Pigou cycle” of boom–bust of industrial fluctuation is plausible: the expectation on the strong technological progress stimulates the investment boom, although the expectation is not realized ultimately (Pigou (1926), Christiano and Fujiwara (2006)). Aside from the well-maintained price stability, we can mention factors which might work to delay the timing of tightening of monetary policy as follows: the need for international cooperation at the time of the October crash in 1987 with Japan as the largest creditor country as well as tax reforms to introduce the consumption tax in 1988-89, in addition to the apprehension of the consequences of the rapid yen appreciation on economic activity. Ikeo (2006) put emphasis on the absence of corporate governance due to the joy ride of “developmentalism” and the eroded role of the “main bank” as delegated monitor in explaining the excessive credit provision by banks. On the cause of lower potential growth in the 1990s, Prescott and Hayashi (2002) focused on the importance of the negative supply shock arising from the shortening of labor hours. Yet, this did not imply that “nominal income targeting” by using the monetary base as an operating instrument was adopted. The “vector-error-corrections model” confirmed the breakdown of the long-run cointegrating relation between money supply and income or prices, although the cointegration linkage still exists with respect to the total fundraising by moneyholders and economic activity (Bank of Japan (2003)). Miyao (2005) also confirmed the disappearance of the predictive content of M2+CDs in the late 1990s by carrying out cointegration analysis. Yet the unstable demand for money as well as the zero bound on policy interest rate do not imply that money has no role to play in the transmission mechanism of monetary policy. Citing the experience of Japan’s quantitative easing policy, Governor Mervyn King (2002) questioned whether the excess supply of money under the zero interest rate policy would lead to the potency or impotency of monetary policy. 9 At the panel discussion of the Jackson Hall Conference in 2005, I gave my answer to this question: under the quantitative easing policy the extent of the zero interest rate was widened to cover the oneyear maturity in tandem with the increasing amount of reserve target from 5 trillion yen to 30-35 trillion yen. I argued that ample provision of liquidity contributed to preventing the economy from falling into a deflationary spiral. Besides, the additional injection of liquidity into the market complemented the commitment about the future path of the policy interest rate, thereby strengthening the “policy duration effect”. Furthermore, at the satiation level of money holdings, a fiscal policy aimed at achieving a zero primary balance by FY2011, combined with the positive rate of increase in the monetary base, contradicts the existence of the “deflation trap”, due to the violation of the transversality condition (Iwata (2005)). The effect of liquidity injection can be interpreted in two ways. First, I recall that Fisher Black reformulated the role of interest rates as an option, assuming that the equilibrium shadow interest rate, or the natural interest rate, can become negative. Yet, individual investors can safely avoid negative interest rates by holding currency at zero interest rate. Thus, the observed zero interest rate can be regarded as a call option on the equilibrium shadow interest rate. Black argued that the long-term interest rate will remain positive under the “liquidity trap” in the presence of a zero bound on nominal short rates, because of the more-than-usual term premiums and the expectation of future development of the short-term interest rate at zero embedded in the longterm interest rate. The commitment on the duration of the zero interest rate policy suggests that the shadow interest rate will be negative, as long as deflation is expected to persist into the future; the longer the duration of the zero nominal interest rate, the larger the size of negative interest rate. 10 Accordingly, while the additional liquidity injection strengthened the commitment on the duration of the zero interest rate policy, it was supposed to result in more currency holdings (Chart 3). Secondly, we can add a new insight into the role of money; money provides a liquidity service which is not identical to the service provided by government bonds. If we reformulate the utility function to include not only money but also bonds of various maturities (money and bonds in utility function), the zero short-term interest rate is not equivalent to the zero marginal utility of money, because there remains the arbitrage relationships with the longer maturity bonds with positive interest rates (Iwamura, Shiratsuka and Watanabe (2006)). As long as the marginal utility of money remains positive, the “satiation of money holdings” will not emerge even though the zero bound on short-term interest rates appears in the economy. In this case, the increase of real money balance can affect the market interest rates, pushing down the forward rate relative to the future rate. As a result, the spread between the forward and the future rate has never closed under the quantitative easing policy (Chart 4, 5). 11 Actually Kimura, Kobayashi, Muranaga and Ugai (2002) confirmed the possibility of the infinite interest rate elasticity of money demand in the vicinity of the zero short-term interest rate. In other words the question is whether the excess supply of money at the zero marginal utility of money or at the satiation level of money holdings will lead to massive substitution for risky financial and real assets or the accumulation of “idle money balance”. Notably, critics on the quantitative easing policy pointed to the useless and harmful accumulation of idle money balance by the banking sector. Yet it may be noted that the effect on the risk premium or the credit spread through ortfolio rebalancing under the zero short-term interest rate is not excluded, though the effect seems to be small (Kimura and Small (2006)). The empirically estimated shadow price reflected the policy duration effect linked to the persistence of deflation under the quantitative easing policy; it reached the bottom (the negative value of 6%) in early 2003, when the deflationary expectation reached the peak. It became close to zero, when the quantitative easing policy was expected to be abandoned (Ichiue and Ueno (2006)). From the third episode, we can draw the following two lessons. First, the large option-like value of nominal interest rates at zero, or close to zero under persistent deflationary expectations stimulates the incentive to hold currency. At the same time, the injection of liquidity complemented and reinforced the policy duration effect of the zero interest rate policy, serving to flatten the yield curve (Ichiue and Ueno (2006)). Secondly, in contrast, if money provides better liquidity services than government bonds, then the increase in real money balance affects the market interest rates, independently of the expectation channel arising from the commitment on the duration of expansionary monetary policy. New framework for the conduct of monetary policy In early March 2006 the Bank of Japan introduced a “new framework for the conduct of monetary policy” when it ended five years of quantitative easing policy. The “understanding of medium- to longterm price stability” provided “common knowledge” to the market participants. 12 Further, the new framework introduced two perspectives on examining economic activity and prices; the first perspective is examining, as regards economic activity and prices one to two years in the future, whether the outlook deemed most likely by the Bank follows a path of sustainable growth under price stability. In the second perspective, we identify the potential risks beyond the forecast period. For instance, excessive investment induced by sustained expansionary monetary policy may give rise to undesirable wide fluctuations of economic activity. The second perspective is designed to cope with the situation where the probability of the event is low, yet the damage to the economy could be quite large if it materializes. This second perspective corresponds to the risk management approach to monetary policy of Greenspan or the “mini-max approach to monetary policy management under Knightian uncertainty”. We have observed the upward revision of the potential growth rate under the circumstances of low real long-term interest rates on the global market. Recent developments in monetary aggregates suggest a return to the equilibrium trend, after the sustained upward deviation from the equilibrium trend under the zero interest rate and the quantitative easing policy. Given the lessons from the second episode, we should cautiously watch the developments in money and credit, and examine the policy implications of changes in monetary and credit aggregates, as the role of money is more subtle and far-reaching as suggested by the option-like value of currency holdings and liquidity effect under the quantitative easing policy. References [1] Black, F. (1995) “Interest Rates as Options,” Journal of Finance, 50. [2] Bank of Japan (1975) “On the Importance of Money Supply in Japan” (in Japanese), Bank of Japan Research Papers, July 1975. [3] Bank of Japan (2003) “The Role of the Money Stock in Conducting Monetary Policy,” Bank of Japan Quarterly Bulletin, May 2003. [4] Christiano, L., and Fujiwara, I. (2006) “Bubble, Excess Investment, Shorter Work Hours and the Lost Decade” (in Japanese), Bank of Japan Working Paper Series, No. 06-J-08. [5] Friedman, M. (1985) “Monetarist in Rhetoric and in Practice,” in Monetary Policy in Our Times, eds. Ando, A., Eguchi, E., Farmer, R., and Suzuki, Y., MIT Press. Iwamura, Shiratsuka and Watanabe (2006) argued that this fact is difficult to explain in the absence of differentiated liquidity services provided by money and government bonds. Yet, there arises a further question as to why money can provide liquidity services superior to bonds. The technological function of money as memory on record-keeping on market transactions may be a partial answer (Kocherlakota (2005)). The public information shared commonly by Board Members and market participants is likely facilitate coordinated action toward returning to the normal state of the economy. [6] Gerlach, S., and Svensson, E.O. (2002) “Money and Inflation in the Euro Area: A Case for Monetary Indicators?” CEFP Discussion Paper, No. 3392. [7] Hayashi, F., and Prescott, E.C. (2002) “The 1990s in Japan: A Lost Decade,” Review of Economic Dynamics, Vol. 5, 1. [8] Ichiue, H., and Ueno, Y. (2006) “Monetary Policy and the Yield Curve at the Zero Interest: The Macro-Finance Model of Interest Rates as Options,” Bank of Japan Working Paper Series, No. 06-E-16. [9] Ikeo, K. (2006) “The Joy Ride and Self-protection of Developmentalism: Financial System and the Heisei Economy” (in Japanese), NTT Publication. [10] Iwamura, M., Shiratsuka, S., and Watanabe, T. (2006) “Massive Money Injection in an Economy with Broad Liquidity Services: The Japanese Experience 2001-2006,” paper presented at the Japan Project Meeting organized by the NBER conference in Tokyo. [11] Iwata, K. (2005) “The Role of Price Stability Anchor in Extricating Japan from Deflation,” speech at the Jackson Hall Conference, August 2005. [12] Kimura, T., Kobayashi, H., Muranaga, J., and Ugai, H. (2002) “The Effect of Quantitative Monetary Easing at Zero Interest Rates,” IMES Discussion Paper Series, No. 2002-E-22. [13] Kimura, T., and Small, D. (2006) “Quantitative Monetary Easing and Risk in Financial Asset Market,” The B.E. Journals in Macroeconomics, Vol. 16, Issue 1. [14] King, M. (2002) “No, Money, No Inflation: the Role of Money in the Economy,” The Quarterly Bulletin of the Bank of England, Summer 2002. [15] Kiyotaki, N., and Moore, J. (1997) “Credit Cycles,” Journal of Political Economy, Vol. 105, No. 2. [16] Kocherlakota, N. (1998) “Money is Memory,” Journal of Economic Theory, 81. [17] Miyao, R. (2005) “Use of the Money Supply in the Conduct of Japan’s Monetary Policy: Reexamining the Time-Series Evidence,” The Japanese Economic Review, Vol. 56, No. 2. [18] Neuman, M.J.M. (2003) “The European Central Bank’s First Pillar Reassessed.” [19] Pigou, A. (1926) “Industrial Fluctuations.”
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Statement by Mr Toshihiko Fukui, Governor of the Bank of Japan, concerning the Bank's Semiannual Report on Currency and Monetary Control, before the Committee on Financial Affairs, House of Councillors, Tokyo, 31 October 2006.
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Toshihiko Fukui: Overall review of the Bank of Japan’s conduct of monetary policy Statement by Mr Toshihiko Fukui, Governor of the Bank of Japan, concerning the Bank's Semiannual Report on Currency and Monetary Control, before the Committee on Financial Affairs, House of Councillors, Tokyo, 31 October 2006. * * * Introduction The Bank of Japan submitted its Semiannual Report on Currency and Monetary Control for the second half of fiscal 2005 to the Diet on June 9, 2006. I am pleased to have this opportunity to present an overall review of the Bank's conduct of monetary policy. I. Developments in Japan's economy Japan's economy is expanding moderately. Exports have continued to increase due to the expansion of overseas economies. Business fixed investment has also continued to increase against the background of high corporate profits and favorable business sentiment. The positive influence of the strength in the corporate sector has been feeding through into the household sector. While firms have been increasingly feeling a shortage of labor, the number of employees has been increasing steadily and wages have also been rising gradually. In this situation, private consumption has been on an increasing trend. With the rise in demand both at home and abroad, production has been increasing, and inventories have been more or less in balance with shipments. Looking forward, Japan's economy is likely to experience a sustained period of expansion with a virtuous circle of production, income, and spending in operation. There are various risks concerning future developments in Japan's economy. For example, although international commodity prices, primarily crude oil prices, have declined since posting record highs this summer, they still remain at high levels. In this situation, whether the world economy can maintain sustainable growth while containing inflationary risks continues to warrant attention. On the price front, domestic corporate goods prices have been increasing recently. However, the pace of increase is expected to slow in the immediate future, due to the recent drop in international commodity prices. The year-on-year rate of change in the consumer price index (CPI; excluding fresh food) has been on a positive trend, although retroactive revisions following the rebasing of the index caused the figure to be revised downward. The output gap is positive and is likely to widen at a moderate pace going forward. Under these circumstances, the year-on-year rate of change in the CPI is projected to continue to follow a positive trend. As for financial conditions, the environment for corporate finance has been accommodative. In the corporate bond and CP markets, the issuing environment has been favorable. Private banks have been maintaining a proactive lending posture. Credit demand in the private sector has been rising and the amount outstanding of lending by private banks thus has continued to increase. II. Conduct of monetary policy The Bank terminated the quantitative easing policy in March and raised the uncollateralized overnight call rate target from effectively zero percent to around 0.25 percent in July. For the first time in about five years, interest rates in the money market are again above zero, and the market mechanism has started to function again. Despite such a significant change in the environment, financial markets have remained stable. A factor that contributed to the smooth policy shift was that the new framework for the conduct of monetary policy, which the Bank introduced in March when it terminated the quantitative easing policy, functioned effectively as a means of communicating with market participants and the public. Regarding the future path of monetary policy, the Bank will conduct monetary policy by carefully assessing economic activity and prices under the new framework. If developments in economic activity and prices follow the Bank's projection presented in the Outlook Report, the Bank will adjust the level of the policy interest rate gradually in the light of these developments. Of course, the timing of any policy change and the level of interest rates will also depend on these developments. The Bank is determined to conduct monetary policy appropriately in the light of developments in economic activity and prices, and contribute to sustainable economic growth under price stability.
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Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at a meeting with business leaders, Osaka, 27 November 2006.
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Toshihiko Fukui: Recent developments in economic activity in Japan Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at a meeting with business leaders, Osaka, 27 November 2006. * * * Today I will explain the Bank of Japan's view regarding recent developments in economic activity and prices and the basic thinking behind its conduct of monetary policy. In addition, I will touch upon the issues facing Japan's financial system. Introduction Today I will explain the Bank of Japan's view regarding recent developments in economic activity and prices and the basic thinking behind its conduct of monetary policy. In addition, I will touch upon the issues facing Japan's financial system. I. The current situation and the outlook for economic activity and prices Japan's economy has been expanding moderately. The current phase of economic recovery began in January 2002. By the end of November, the economy will have experienced a long economic expansion that has lasted for four years and ten months. This sustained period of economic expansion is likely to continue. Recent economic indicators have shown mixed developments. For example, while the results of the Family Income and Expenditure Survey and machinery orders were weak, the preliminary estimate of real GDP growth turned out to exceed market expectations, recording 2.0 percent in the JulySeptember quarter on an annualized quarter-on-quarter basis. These mixed results seem to have introduced some volatility into market participants' view of the current economic situation. The important point at this juncture is to examine whether these indicators as a whole suggest any changes in the fundamental mechanisms underlying economic activity and prices. In the latest Outlook for Economic Activity and Prices (the Outlook Report), which was released at the end of October, the Bank made public its projection for the next two years or so. The Bank projected that the economy was likely to experience a sustained period of expansion with domestic and external demand increasing and the positive influence of the strength in the corporate sector feeding through into the household sector. Although economic indicators have shown mixed developments since the Bank released its projection, the Bank considers that they do not suggest a change in the mechanisms underlying the economy. The Bank will continue to confirm this by carefully assessing various relevant economic indicators as well as microeconomic information. Let me touch upon a few important factors in this regard. The first factor is developments in overseas economies, especially the U.S. economy. The pace of U.S. economic growth has been decelerating recently due mainly to the decrease in housing investment. The advance estimates of real GDP for the July-September quarter increased at an annual rate of 1.6 percent on a quarter-on-quarter basis. Business fixed investment has continued to increase against the background of high corporate profits, and the deceleration in the growth of private consumption has been moderate supported by the increase in household income and the drop in gasoline prices. Therefore, the U.S. economy is likely to realize a soft landing and to move toward sustainable growth. However, it is important to continue to pay attention to the extent of adjustment in housing prices and whether this affects private consumption, as these factors could impact on production and exports in Japanese industries, for example, in the IT-related industry. Upside risks should also be watched closely, such as the risk of inflation expectations rising in the U.S. economy, given that the rate of resource utilization is high. Taking a look at the global economy as a whole, the Chinese economy continues to expand strongly, and in the euro area, the momentum of economic recovery is becoming more evident. Oil-producing countries, such as those in the Middle East, continue to experience an economic boom. The global economy is likely to keep expanding even in the face of a modest slowdown in the U.S. economy, as expansion in other economies may be expected to offset it. The second factor is whether strong corporate performance will continue. Corporate profits continue to be high as indicated in the semiannual book closings for the first half of fiscal 2006, and business fixed investment continues to increase. Although machinery orders, a leading indicator of business fixed investment, declined substantially in the July-September quarter, this does not indicate a change in the underlying trend of business fixed investment, because the decline was partly a reaction to the sharp increase in the previous quarter and is largely attributable to the fall in orders for cellular phones. The uptrend in corporate profits and business fixed investment is evident in the September Tankan (Short-Term Economic Survey of Enterprises in Japan) as well as in the results of various surveys conducted on small firms. However, the Bank does not consider the current state of business fixed investment indicative of overheating. The recent growth in business fixed investment has been supported by the fact that firms are factoring the ongoing rapid growth of the global market into their business strategies, and at the same time are still displaying a strong tendency to evaluate investment profitability strictly. Given that financial conditions continue to be extremely accommodative, however, attention should be paid to the risk of a further acceleration of firms' investment leading to an excessive build-up of capital stock. Whatever the case, the Bank will further examine developments in the corporate sector based on data such as the upcoming December Tankan. The third important factor is the extent to which the positive influence of the strength in the corporate sector continues to feed through into the household sector. The number of employees has been rising at an annual rate of 1.0-2.0 percent driven by the strength in corporate activity. Looking at developments in wages per worker, while regular payments have been flat year on year, special payments and overtime payments continue to rise, and as a result wages per worker have been rising moderately. In this situation, private consumption, especially outlays for services and durable consumer goods, continues to trend upward. The preliminary estimates of real GDP for the JulySeptember quarter indicated a decrease in private consumption by 0.7 percent on a quarter-on-quarter basis, but this seems to have been attributable to the substantial decline in consumer spending reported in the Family Income and Expenditure Survey, which provides the basic statistics for consumer spending. It should be noted that figures in the Family Income and Expenditure Survey were considerably weaker than sales statistics and other statistics related to consumption. Still, even allowing for this, private consumption was somewhat weak in the July-September quarter, and therefore the Bank will watch closely developments in private consumption from the autumn onward so as to check whether this weakness was due to temporary factors, such as unfavorable weather and the tax rise in tobacco products. Lastly, in relation to this point, developments in wages and prices are important factors that need to be watched closely. The Bank expects the year-on-year rate of increase in the consumer price index (CPI; excluding fresh food, on a nationwide basis) to rise gradually with the output gap remaining positive and expanding at a moderate pace while downward pressure from declining unit labor costs (labor costs per unit of output) weakens. If, in contrast with past experience, productivity keeps rising with wage increases lagging behind in spite of the prolonged economic expansion, there may be no upward shift in the inflation rate. Despite the steady tightening of labor market conditions, the rate of increase in wages has remained moderate so far because, while employers faced with intensified global competition are maintaining their restraint on labor costs, employees, having experienced a severe employment situation, continue to prefer stable employment to a wage increase. Although the population of those 15 years old and over has been leveling off, the number of employees has been increasing steadily. If the number of employees keeps increasing in line with the continuing economic expansion, a further tightening of labor market conditions will become inevitable. In this situation, it is natural to assume that upward pressure on wages including regular payments will increase gradually. However, since the point at which this will happen is not clear, developments in wages and the underlying trend in prices continue to require close monitoring. II. Conduct of monetary policy I would like to touch on the Bank's thinking regarding the conduct of monetary policy based on the assessment of economic activity and prices I have just referred to. With regard to the future course of monetary policy, as long as economic activity and prices are expected to develop in line with the Bank's projection in the Outlook Report, the Bank will adjust the level of interest rates gradually in the light of developments in economic activity and prices, while maintaining the accommodative financial conditions ensuing from very low interest rates for some time. As I have stated repeatedly, the adjustment process will proceed gradually. This will avoid impeding the expansion of Japan's economy, and will instead facilitate the realization of sustainable economic expansion. The specific timing of the move will be decided based on careful assessment of developments in economic activity and prices and thorough discussion of the issue among members at each Monetary Policy Meeting. In making such decisions, the Bank will carefully examine individual economic indicators as well as other relevant information in light of the mechanisms underlying economic activity and prices indicated in the October Outlook Report and assess whether economic activity and prices will develop in line with the Bank's projection. III. Issues facing Japan's financial system Next, let me turn to Japan's financial system. Japanese financial institutions have finally overcome the nonperforming-loan (NPL) problem they had been wrestling with since the bursting of the asset price bubble in the 1990s. In addition, the capital base of Japanese financial institutions has strengthened and Japan's financial system has regained its stability. In such circumstances, financial institutions are ever more focused on developing and offering a wider range of financial services closely tailored to customer needs. For example, banks have increased the variety of financial products offered over the counter, such as investment trusts and private pension policies in addition to conventional bank deposits, and sales of such products have expanded. They have also been more innovative in designing new types of residential mortgage loan products, and as a result, residential mortgage loans have come to account for about a quarter of all bank loans, up from around 10 percent in the 1990s. Finally, the variety of commercial loan products has increased. Banks have increased their syndicated loans and have started to offer small-sized non-collateralized business loans to small and medium-sized firms using the so-called "credit scoring model," a statistical credit examination method. Along with efforts to overcome the NPL problem, financial institutions have been preparing themselves to develop innovative lines of business. Smooth implementation of such new business lines requires financial institutions to accurately identify and assess the risks inherent to each new business and then to manage those risks accordingly. Specifically, financial institutions will need to employ the advanced risk management techniques that have been rapidly developed in recent years so as to appropriately manage the various risks involved in each new business area, for example, credit risks, market risks, and operational risks, and thereby achieve sound business management and enhance profitability. Competition among financial institutions to provide various financial services and develop advanced risk management techniques will not only strengthen financial institutions' ability to provide valueadded services but also enhance the functioning of financial markets, thus leading to increased financial system stability. Enhancing the functioning of financial markets is also very important for firms. This will not only increase the efficiency with which firms can raise and invest funds, but will also promote business restructuring, which has been increasing among Japanese firms, as well as facilitate balance-sheet adjustments. The U.S. economy has been growing for some time now - a fact due in no small part to the increased productivity accompanying innovations in information and communication technology and the improved flexibility in the business management of firms made possible by the deepening and expansion of financial markets. Similarly in Japan, strengthening the business management of financial institutions and further enhancement of the functioning of financial markets are essential in invigorating the economy. The Bank will continue to make full use of occasions such as its on-site examinations, off-site monitoring, and various seminars hosted by the Center for Advanced Financial Technology to support the initiatives of financial institutions to strengthen their business management. Through such activities, we intend to promote financial institutions' initiatives to develop and offer new financial services, thus making a greater contribution to regional economies. Closing remarks As I have explained, Japan's economy is expanding moderately. Looking at the economic situation in the Kansai region, corporate activity has increased due partly to strong exports, and a resulting improvement in corporate profits is being observed, not only at large firms but also at small firms. In order for Japan's economy to continue sustainable growth in the face of various challenges including the declining population, it is crucial for all regions and industries to persist with their efforts to innovate. Since, along with the Tokai and Kanto regions, the Kansai region is pulling Japan's economy forward, I fully anticipate that your originality and inventiveness will continue to play a leading role. As for the Bank, it will continue to support the economy from the monetary side to achieve sustainable economic growth with price stability.
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Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, to the Board of Councillors of Nippon Keidanren (Japan Business Federation), Tokyo, 25 December 2006.
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Toshihiko Fukui: Developments in Japan’s economy in 2006 and the outlook for 2007 Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, to the Board of Councillors of Nippon Keidanren (Japan Business Federation), Tokyo, 25 December 2006. * * * Introduction There is now less than a week until the end of 2006. The year has been marked by the sustained recovery of Japan's economy, which began in January 2002, exceeding the record of the Izanagi boom, the longest postwar economic expansion (57 months during 1965-70). The Bank of Japan terminated the quantitative easing policy in March and in July returned to pursuing a monetary policy in which it controls interest rates. Although Japan's economy still faces further structural changes going forward, the year 2006 can be regarded as a year of steady progress toward normalization after the long adjustment phase since the bursting of the bubble. Today I will review this year's developments in the economy and prices as well as the conduct of monetary policy, and talk about the outlook for 2007. I. Developments in overseas economies One of the factors behind the sustained recovery of Japan's economy is the continued strong growth of overseas economies. According to the International Monetary Fund (IMF), the global economy is likely to register growth of around 5 percent in 2006 for the third consecutive year. It is a generally accepted view that the global economy will continue to expand in 2007, at around the same pace as in 2006, across a broader range of regions. As a risk factor to this outlook, developments in the U.S. economy should be mentioned. The pace of growth in the U.S. economy has been slowing recently reflecting decreases in housing investment, while private consumption has so far been firm with a limited slowdown in the pace of growth. Since the adjustment in the housing market seems to be continuing, attention should be paid to future developments in that market and the possible negative effects on private consumption and production. As for prices, the rate of increase in the core consumer price index is still relatively high, despite a moderate decline in crude oil prices. We basically think that inflation pressures are likely to ease gradually in line with the deceleration of economic expansion and the U.S. economy is likely to realize a soft landing and move toward sustainable growth, but both upside and downside risks should be borne in mind. With regard to developments in other regions, China's economy has continued to expand strongly and economic recovery in the euro area has become more evident. Oil-producing countries, especially those of the Middle East, and the ASEAN economies continue to show steady growth. Given these developments, our main scenario is that the global economy as a whole will likely keep expanding through 2007, with possible slowing growth in the U.S. economy being offset by high growth in other regions. II. Developments in the corporate sector Japanese firms are succeeding in utilizing the strong growth of overseas economies to realize good business performance. In 2006, the strength in the corporate sector, as seen in steady growth of profits and increases in business fixed investment, became more evident. The recently released December Tankan (Short-Term Economic Survey of Enterprises in Japan) shows that firms are projecting growth in their current profits for the fifth consecutive year since fiscal 2002 and the ratio of current profits to sales is exceeding the peak reached in the bubble era. In this situation, business sentiment continues to be favorable and firms are planning to increase fixed investment for the fourth consecutive year. Moreover, their projections of both current profits and fixed investment for fiscal 2006 have been revised upward from the September Tankan. Nevertheless, we believe the current strength in business fixed investment does not indicate "overheating," given that firms are increasing investment to reinforce their production capacity not only to meet domestic demand but also to capture opportunities for higher profits in growing overseas markets. Firms continue to scrutinize the investment profitability of each project amid greater exposure to the discipline of the capital market. Continuation of this disciplined investment stance under accommodative financial conditions is important if Japan's economy is to follow the path of sustainable growth. III. Developments in the household sector The positive influence of the strength in the corporate sector is feeding through to the household sector at a moderate pace. Throughout 2006, the number of employees has increased steadily. A closer look reveals that not only part-time employees but also full-time employees have been increasing steadily. Many firms seem to have hired a greater number of new graduates this year. The December Tankan shows that both large and small firms are planning to continue hiring more new graduates in the coming year. Labor market conditions are tightening as suggested by the fact that the annual average of the ratio of job offers to applicants is almost certain to exceed 1.00 for the first time in 14 years and the unemployment rate decreased further from last year's level. As for wages, with overtime and bonus payments rising, household income overall is increasing. Nonetheless, the pace at which the positive influence of the corporate sector is feeding through to the household sector is, in fact, slow relative to the corporate sector's strength. This is evident especially in regular payments, which remain virtually unchanged year on year. This seems to be responsible for the often-heard statement that it is difficult to realize that Japan is in the middle of the longest postwar economic expansion. The slowness of the increase in regular payments is attributable to both the stance of firms and the preference of employees: given the intensifying global competition, firms remain cautious about raising regular payments because this is likely to push up fixed costs; while employees, having experienced a severe employment situation, continue to prefer stable employment to a wage increase. However, in a situation where the population of those 15 years old and over has been leveling off, further tightening of labor market conditions seems inevitable if demand for employees remains on the rise in line with the continuing economic expansion. Given this situation, upward pressures on wages are likely to increase gradually. Wages for part-time and temporary workers have, in fact, started rising. If an increase in wages becomes more apparent, the pace of increase in household income is expected to accelerate, thereby firming the sustainability of the upward trend in private consumption. Some indicators related to private consumption have recently been somewhat sluggish, partly reflecting unfavorable weather conditions and consumers holding back from buying before the introduction of new products. Although these developments continue to require close monitoring, our basic view is that private consumption will remain on the rise if increases in household income are in prospect. Although, as I explained, developments in the corporate sector have been somewhat stronger than projected while those in the household sector have been somewhat weaker, we believe the basic mechanism of an economic expansion based on a virtuous circle of production, income, and spending is in operation. Nevertheless, given the fact that there are some weak developments in indicators related to private consumption and consumer prices, we will carefully examine various types of incoming data and information. IV. Developments in prices With these developments in the economy, the environment surrounding prices has been changing, albeit gradually. In the December Tankan, for the first time in more than a decade, the number of firms that reported a shortage of production capacity outnumbered those reporting an excess, and it has become clear that firms are increasingly feeling a shortage of labor. These developments imply that resource utilization has been rising. Wages are increasing, albeit moderately, particularly in special and overtime payments, and downward pressure on prices stemming from declining unit labor costs has been abating. Furthermore, inflation forecasts of households and firms are being revised upward. For instance, in the December Tankan, the share of firms that replied their sales prices had risen compared to three months earlier increased to levels not seen since the early 1990s. With such changes in the environment surrounding prices, year-on-year changes in domestic corporate goods prices rose to around 3.5 percent in mid-2006, reflecting increases in prices of international commodities such as crude oil. Although the pace of increase has recently been slowing somewhat due to a softening of crude oil prices, it is expected to continue its uptrend if there were no large fluctuations caused by commodity prices and foreign exchange rates. On the other hand, although the year-on-year rate of change in the consumer price index (CPI) has been on a positive trend, the rate of increase remains very low relative to the improvement in the economic situation. It is possible that the sensitivity of prices to changes in economic activity has been decreasing compared to the past. This tendency has been observed in recent years in economies overseas as well. It is thought that economic globalization as well as deregulation and advances in information and communication technology are behind this phenomenon. If competition with products imported from newly industrialized countries heightens, inflationary pressure is likely to be contained. Likewise, if firms, faced with intensified global competition, become more cautious in raising wages, price developments will be influenced. In the case of Japan, where year-on-year changes in the CPI have been in the process of improving from negative territory, the rate of increase in the CPI tends to be low compared with other major economies. We project that the rate of increase in the CPI will gradually rise as the economy continues its long expansion. However, the pace at which it rises should continue to be watched carefully. V. Conduct of monetary policy in 2006 Looking back on the conduct of monetary policy this year, the Bank terminated the quantitative easing policy in March, and in July it raised the operating target of money market operations (the uncollateralized overnight call rate) from "effectively zero percent" to "around 0.25 percent," bringing the zero interest rate environment to an end after five years. An underlying factor that enabled us to make this decision was the fact that structural adjustment pressure in the corporate sector and the financial system, which had continued since the bursting of the economic bubble, had mostly been removed. When we introduced the quantitative easing policy, the Japanese economy was in a recession triggered by the collapse of the global IT bubble. Financial institutions were burdened by a huge amount of nonperforming loans (NPLs) and there was strong concern about the stability of the financial system. In this situation, a risk of the economy falling into a vicious circle of falling prices and deteriorating economic activity, in other words a deflationary spiral, was also a concern. In these circumstances, the quantitative easing policy played a significant role in maintaining the stability of the financial markets and the accommodative financial environment and in preventing a contraction of economic activity. Under the accommodative financial conditions, firms have, after great effort, cast off the three excesses -- excess employees, excess capacity, and excess debt. Financial institutions have almost resolved the NPL problem, and stability was regained in the financial system. Major and regional banks posted their highest-ever profits in fiscal 2005, exceeding the record of the bubble period, and their interim results indicated that their profits have remained high in the current fiscal year. Repayment of public funds totaling 12 trillion yen injected into financial institutions proceeded, with the three major financial groups completing redemption in autumn this year. With the strengthening of the capital position, financial institutions' risk-taking capability has been recovering and as a result their lending attitude has become positive. Against this background, the year-on-year rate of change in outstanding bank loans has turned positive this year for the first time since 1996. VI. New framework for the conduct of monetary policy As the Japanese economy is heading toward normalization, we have altered the framework of monetary policy to support movement in that direction. Under the quantitative easing policy, we conducted monetary policy in line with the commitment expressed in terms of developments in the CPI. This was a way, when we faced the zero constraint on nominal interest rates, to produce an additional monetary easing effect by intentionally sacrificing the flexibility of policymaking. In contrast, the new framework for the conduct of monetary policy, introduced when the quantitative easing policy was terminated, is a forward-looking framework whereby the Bank's thinking behind the conduct of monetary policy is made public along with its projection for the economy and prices and risk factors. At the same time, it was announced that the Policy Board members' "understanding of price stability from a medium- to long-term viewpoint" expressed in the year-on-year changes in the CPI was an approximate range between zero and two percent, and that the members would conduct monetary policy in the light of this understanding. Japan's economy is expected to continue its expansion through fiscal 2007 with gradual rises in the rate of increase in the CPI. In other words, Japan's economy is expected to achieve sustainable growth under price stability. Our assessment is that an upside risk to this projection would be large fluctuations in economic activity and prices as the stimulative effect of monetary policy is further increasing, while a downside risk would be the possibility that economic expansion and rising prices may stall. However, at present, there is no bias toward either of these risks. We will conduct monetary policy in light of this assessment, and if economic activity and prices develop in line with the projection, we will adjust the level of interest rates gradually in the light of developments in economic activity and prices, while maintaining the accommodative financial conditions ensuing from very low interest rates for some time. Of course, a forward-looking approach does not imply that we have predetermined the level of the target rate in the future or the timing of a policy change. There are inflows of new information regarding the state of economic activity and prices every day. We will make our best judgment based on careful assessment of such incoming data and a candid view of the Japanese economy in the future. Closing remarks Japan's economy is expected to continue its moderate expansion in the coming year. However, it will be increasingly important to address medium- to long-term issues that Japan's economy faces, such as the declining birthrate and aging population as well as fiscal consolidation. To provide a basis for dealing with these issues, achieving sustainable economic growth under price stability is vital from a macroeconomic policy perspective. Minimizing economic and price fluctuations is an important prerequisite for firms and households to engage in economic activity without anxiety. Fulfillment of this prerequisite will lead to full utilization of Japan's economic potential and its realization in actual growth. The Bank will continue to conduct monetary policy appropriately by utilizing and refining the new framework to support the attainment of the desired state of the economy.
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Opening remarks by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the Int. Symposium "Ten Years After the Currency Crisis: Future Challenges for the Asian Economies and Financial Markets", hosted by the CeMCoA, Bank of Japan, Tokyo, 22 January 2007.
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Toshihiko Fukui: The dynamism of Asian economies and central bank cooperation in the region Opening remarks by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the International Symposium "Ten Years After the Currency Crisis: Future Challenges for the Asian Economies and Financial Markets", hosted by the Center for Monetary Cooperation in Asia (CeMCoA), Bank of Japan, Tokyo, 22 January 2007. * 1. * * Introduction Good morning, ladies and gentlemen. Welcome to the first international symposium hosted by the Center for Monetary Cooperation in Asia, or CeMCoA for short. CeMCoA was established within the International Department of the Bank of Japan about a year ago with a view to promoting international cooperation among Asian central banks. Today, I am very pleased to welcome my close friends from the Asian central banking circle and the International Monetary Fund. Governor Zeti from Malaysia, Governor Tarisa from Thailand, Governor Abdullah from Indonesia, Governor Tetangco from the Philippines, and Managing Director Rodrigo de Rato of the IMF, I would like to thank all of them for joining us as guest speakers. I would also like to extend my heartfelt gratitude to all the distinguished audience gathering here. This morning, we would like to discuss the dynamism of Asian economies and the regional cooperation among central banks as well as the IMF. Looking at the Asian economies, China and India often attract attention, but at the same time no one can afford to overlook the importance of ASEAN countries. Japanese industries and financial institutions have a long history of close relationship with these economies, and will continue to do so for mutual benefits. Interdependence in Asia has come a long way despite the Asian currency crisis a decade ago. As demonstrated by the significant recovery and expansion in the last decade, the Asian economies are expected to make great leaps forward in the next decade. Today's guest speakers are the ones who will support these leaps. I believe this is a very good opportunity to discuss a forward-looking view of the Asian countries. 2. Economic dynamism in Asia As you may recall, the Asian currency crisis, which started with the sharp decline of the Thai baht in July 1997, spread to neighboring countries in a short period of time. Some ASEAN economies at that time suffered disruptions in their foreign exchange and financial markets, the massive outflow of capital resulted in the drying up of foreign reserves, the deterioration of banking systems and negative economic growth. Ten years later, everything is different: the foreign exchange and financial markets are much more stable and the currencies sometimes face upward rather than downward pressure; foreign direct investment and other capital inflow continues to grow with the accumulation of foreign reserves; the banking system has been strengthened through restructuring; and the economies have grown at a steady and sustainable pace of 5% on average since 2000. While there were indescribable difficulties to overcome the adverse effects of the crisis, the present performance clearly demonstrates the success of policy efforts and the underlying dynamism of the economies. I hope the speeches by the Governors will enlighten us about the changes in economies and dynamism after the crisis. 3. Regional cooperation Turning to policy coordination, the crisis became the starting point for various initiatives in the region. Exposed to the weakness in the international financial architecture, the ministries of finance and central banks became aware of the importance of regional cooperation and began to address the source of weakness. The Chiang Mai Initiative, as a complement to the IMF facilities, was agreed upon among ASEAN + 3 to build a framework of emergency liquidity support through a network of bilateral foreign exchange swap arrangements. Based on the analysis of the crisis, efforts have been made to reduce over-reliance on the banking sector for financial intermediation. The Asian Bond Markets Initiatives (ABMI) is another regional cooperation by ASEAN + 3 to foster local capital markets. Sharing the same objective with the ABMI, the Executives' Meetings of East Asia and Pacific Central Banks, or EMEAP, consisting of eleven central banks and monetary authorities in the region, started the Asian Bond Fund project. By utilizing some foreign reserves of member central banks collectively, the EMEAP launched two investment funds; one for investing in US dollar-denominated public bonds issued by the member countries, and the other for investing in local currency-denominated public bonds, to help not only to provide a convenient and low-cost instrument for market participants but also to identify and remove impediments to the respective local markets. 4. Future challenges for the Asian economies and financial markets In line with the good performance of regional economies and the progress in policy coordination among central banks and monetary authorities, economic integration in the region is gradually taking root. It is reported that intra-regional trade in East Asia has recently reached around half of the total, which is comparable to that of NAFTA and slightly less than that of the EU. Bilateral and regional free trade agreements are spreading throughout Asia. In addition, ASEAN is accelerating the process for building the ASEAN Economic Community (AEC) by 2015. It will be interesting to see how the present banking and other financial services change when a single market for goods and services is formulated in ASEAN. I hope the Governors can provide us with insights into developments of the AEC. With the globalization of the world's financial markets, large capital flows will continue to have a strong impact on open economies. This holds true for most of the Asian economies including the ASEAN. It is, and will surely be, the most difficult task for any monetary authorities to maintain the stability of foreign exchange rates, the free flow of capital, and the independence of monetary policy simultaneously. The answer to this proposition probably lies in the resilience of markets. In order to increase the ability to absorb external shocks from massive capital flows, the priority seems to strengthen the function of foreign exchange and financial markets in the region as a whole. In this regard, frequent exchange of information, deep analysis and concerted efforts by the EMEAP central banks will contribute to addressing risks and vulnerabilities in the markets. Such collaborative actions may cover the roles of the IMF, which commits itself to extensive reform to meet new challenges under the leadership of Rodrigo. Conclusion It is often said that Asia is highly diverse in culture, social framework and the stage of economic development. Since the Asian economies are in many respects very different from the European, we will probably follow our own process for economic integration. In that process, the better functioning of markets through regional cooperation will help provide a better business environment for industries and financial institutions, and lead to more efficient resource allocation. The more-than-ten-year history of EMEAP itself proves that cooperation based on mutual understanding and respect is possible in any circumstances. I am sure the guest speakers have various opinions on today's topics, and we will be able to appreciate their visions through our stimulating discussions. I would be delighted if this symposium helps you build insights into the dynamism of Asian economies and central bank cooperation in the region for the decade to come. Thank you.
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Excerpt of a speech by Mr Kazumasa Iwata, Deputy Governor of the Bank of Japan, at a meeting with Business Leaders, Niigata, 7 March 2007.
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Kazumasa Iwata: The current state of the Japanese economy and its outlook Excerpt of a speech by Mr Kazumasa Iwata, Deputy Governor of the Bank of Japan, at a meeting with Business Leaders, Niigata, 7 March 2007. * * * Introduction Today, as a representative of the Bank of Japan, I am pleased to have this opportunity to present the Bank's view on the current state of the Japanese economy and its outlook. I would also like to explain the Bank's decision to raise the policy interest rate at its Monetary Policy Meeting (MPM) in February as well as the thinking behind its conduct of monetary policy. I. Overseas economic and financial developments Let me start with overseas economies. In the United States, the economy expanded at an annual rate of 2.0-2.5 percent over the last three quarters with housing investment continuing to cool significantly. However, spillover effects from the housing adjustments have been limited, and private consumption has continued to show solid growth. As for price developments, the rates of increase in the core consumer price index (CPI) and in the core personal consumption expenditure (PCE) deflator have been at relatively high levels. Both upside and downside risks currently coexist in the U.S. economy, surrounding the inflation situation and the economic growth rate, respectively. Nevertheless, given the robustness and the flexibility of the economy it is likely to avoid a significant slowdown in the growth rate and to realize a soft landing, returning to its potential growth path from the current 2.0-2.5 percent by late 2007, with a gradual decline in the rate of inflation. In the euro area, economic recovery continues to be solid, while in China and India strong expansion is continuing on the back of growth in demand both at home and abroad. Overseas economies taken as a whole continue to exhibit strong growth. At the G-7 meeting held about a month ago, there was a consensus view that the world economy is likely to keep expanding with more balanced growth. Turning to global financial markets, a plunge in the Chinese stock market at the end of February resulted in large fluctuations in stock prices worldwide and higher volatility in asset prices. Up until then, volatility in asset prices had been very low internationally, resulting in tighter credit spreads and smaller term premiums. With investors appearing "overly complacent" about asset price changes and various other risks, a situation developed in which investors focusing on the interest rate differential between Japan and abroad favored the yen carry trade. Recently, however, there has been some unwinding of this trade. Although these adjustments seem so far to have been limited basically to technical corrections in position-taking by those who felt overexposed, careful attention should be paid to whether the higher volatility in asset prices may have some implications for investors' risk-taking behavior in the future. II. Developments in Japan's economy Against the background of the strong growth in overseas economies, Japan's economy has been experiencing a sustained period of moderate expansion. The economy maintained a rate of growth of about 2 percent from fiscal 2003 to fiscal 2006, a pace which it seems likely to sustain during fiscal 2007. A. Slow permeation of strength in the corporate sector through to the household sector The current economic expansion is now six years old, but partly because of the gradual pace of growth, it is not making itself felt by households to the same extent as in past economic expansions. In the corporate sector, however, corporate profits have been favorable and business fixed investment is growing at a rapid pace, especially among manufacturers. Corporate profits and business fixed investment are expected to keep increasing steadily, and this suggests that the engine of the economic expansion remains intact. Despite the strength in the corporate sector, the pace at which this positive influence has filtered through into the household sector has been slow. Faced with intensifying global competition and greater exposure to the discipline of the capital market, corporate management has been increasing the emphasis it places on raising profitability. Reflecting these factors, growth of wages has been modest. Especially since summer 2006, the effects of the baby-boomers' retirement and of cuts in personnel expenses for local civil workers are exerting additional downward pressure on the growth of wages per person. The modest increase in wages seems also due to management's greater efforts to reduce fixed costs to cope with sharp rises in prices of crude oil and other materials from 2004 through fall 2006, and employees' preference for employment stability over a wage increase after their past experiences of a severe employment situation. With regard to the employment situation, the number of employees has continued to increase steadily at an annualized rate of slightly over 1 percent, and labor market conditions are gradually becoming tighter. The unemployment rate for women was 3.8 percent in January 2007, lower than that for men (4.1 percent), and women's wages have been increasing steadily since 2005. Hourly wages for parttime workers have posted year-on-year increases since 2003, and the rate of increase rose gradually through 2006. Looking forward, wages, including those for men, are expected to rise steadily as labor market conditions become increasingly tight. With the number of employees increasing steadily, household income has continued rising moderately and private consumption has been firm. A more distinct upward momentum in private consumption is likely to emerge as the adverse effects from temporary factors -- such as last year's weather conditions (a long spell of rainy weather in early summer as well as the unseasonably warm winter weather) and consumers' reluctance to buy before the introduction of new products -- fade and wages resume their upward trend reflecting improved labor market conditions. B. Production and inventory adjustments Production exhibited high quarter-on-quarter growth of 2.6 percent in the October-December quarter of 2006, but a downward reaction to this high growth coupled with adjustments in the IT-related sector will likely suppress growth in the January-March quarter of 2007. Unlike inventory adjustments in ITrelated goods during 2002-03 and 2004-05, adjustments this time seem largely due to weaker-thanexpected demand for cellular phones and new game consoles, although the impact of the introduction of a new personal computer operating system has still to be fully ascertained. C. Developments in consumer prices The year-on-year rate of change in the CPI (excluding fresh food) was flat in January, and depending on developments in crude oil prices and foreign exchange rates, it may turn slightly negative in the short term. From a longer-term perspective, however, consumer prices are expected, over time, to display trend increases given that the economy has expanded at an annual rate of around 2 percent over the last four years and that the expansion is expected to be long-lasting. With the continuing economic expansion, the utilization rates of production capacity and of labor have been rising steadily, and they are expected to increase further. As the recent Tankan (Short-Term Economic Survey of Enterprises in Japan) indicates, corporate managers are increasingly feeling shortages of production capacity and labor, while a positive output gap suggests that demand currently exceeds supply in the economy as a whole. Since autumn last year, upward movement in the CPI has been subdued partly because of sluggish growth in private consumption and wages. However, the CPI is expected to resume a moderate upward trend as the effects of the drop in crude oil prices fade out. When considering the effects of the The modest growth of wages, despite increased demand for labor, can be attributed to the flexibility of the labor supply, witnessed for example in an increase in the rate of femaleparticipation in the labor force. fall in crude oil prices, we should note the consequential improvement in Japan's terms of trade and concomitant decrease in the amount of wealth transferred to oil-producing countries, which will boost private consumption in Japan by improving households' real income through higher corporate profits and lower prices. 2 III. Decision at the MPM in February Based on the "New Framework for the Conduct of Monetary Policy" announced in March 2006, the Bank examines future risks from two perspectives. The first perspective examines the prospects as well as risks for the economy and prices basically within a projection period of one and a half to two years. At the MPM held in February, it was judged that Japan's economy "is likely to continue its moderate expansion with a virtuous circle of production, income, and spending in place." It was also judged that although the year-on-year rate of change in the CPI (excluding fresh food) may register around zero in the short run, depending, for example, on developments in the prices of crude oil, it is likely to "increase as a trend" given the expected continuation of the economic expansion. The second perspective extends the horizon beyond that of the above forecasting period and takes into account various risks that would significantly impact the economy should they materialize, even though the probability of such materialization may be low. At the February MPM, it was noted that "[i]f expectation takes hold . . . that interest rates will remain low for a long time regardless of economic activity and prices, there is a possibility that sustained economic growth will be hampered by misallocation of funds and resources through excess financial and economic activities." Based on its assessments from these two perspectives, the Bank has decided to change the guideline for its money market operations so as to encourage the uncollateralized overnight call rate to remain at around 0.5 percent. At the same time, the basic loan rate applicable under the complementary lending facility (the standby lending facility through which the Bank will extend a loan at the request of a counterparty up to an amount not exceeding the value of that counterparty's collateral) was set at 0.75 percent. With respect to the outright purchases of long-term interest-bearing Japanese government bonds, the Bank has decided that purchases will continue at the current amount and frequency for some time. With regard to the future course of monetary policy, the Bank stated that it will adjust the level of interest rates gradually in the light of developments in economic activity and prices, while maintaining the accommodative financial conditions ensuing from very low interest rates for some time. IV. Thinking behind the conduct of monetary policy It takes quite a while for the effects of a monetary policy change to filter through to the economy and prices. Because of the long and variable lag length, the conduct of monetary policy needs to be forward looking, based on the outlook for the economy and prices over a sufficiently long term. The Bank releases the Outlook for Economic Activity and Prices (the Outlook Report) semiannually, in which it describes its forecast for the economy and prices over a horizon of one and a half to two years. The Bank's conduct of monetary policy is based on this forecast. It has become a common practice among central banks to conduct monetary policy based on published forecasts for economic activity and prices. The key point of a "forward-looking policy framework" is to conduct policy on the basis of a forecast of the most likely outlook for the economy and prices, as well as identification of the accompanying upside and downside risks, by conducting a careful analysis of incoming indicators and other relevant data. Especially in cases where the implications of the available data are mixed, the accuracy of the The significance of the transfer of wealth to oil-producing countries can be approximated by the difference between the growth rate of the GDP deflator and that of the domestic demand deflator. Based on this estimation, the transfer of wealth accounted for on average about 0.7 percent of nominal GDP from 2004 through 2006. If this wealth were not transferred to oil-producing countries but instead spent in Japanese markets, it could be expected to deliver a positive fillip to the growth of domestic demand. For details, see K. Hamada and K. Iwata, "National Income, Terms of Trade and Economic Welfare," Economic Journal, Vol. 94, December 1984. forecast should be carefully examined in making policy decisions. Coming to a decision through painstaking examination of the available economic data and other relevant information, therefore, is the basis of forward-looking monetary policy. Arguments that treat the assessment of available data and the conduct of forward-looking monetary policy independently of each other are incompatible with the basic reasoning behind the Bank's new policy framework. Reviewing the forecasts presented in the October Outlook Report in January, it was judged that Japan's economy and prices had so far deviated slightly below the outlook forecasts, but that economic expansion was likely to continue under price stability. Although at the January MPM many members said that they were not confident enough about the outlook to prescribe a policy change, at the February MPM, after examining all available data, most Policy Board members were able to reaffirm that the virtuous circle of production, income, and spending remained intact. This increased their confidence in the outlook for economic activity and prices, and therefore the decision to raise the target rate was taken. In the "New Framework for the Conduct of Monetary Policy," it is stated that Policy Board members will conduct monetary policy in the light of their understanding of what constitutes medium- to longterm price stability. Taking account of the actual measurement bias in the CPI and Japan's history of low inflation, an approximate range between 0 and 2 percent in terms of the year-on-year rate of change in the CPI is generally consistent with the individual distributions given by Policy Board members to describe their own understandings of medium- to long-term price stability. 3 The range includes 0 percent, but this does not mean that the Bank is conducting monetary policy to achieve zero percent inflation. On the contrary, it should be noted that most Policy Board members' median figures fell on one side or the other of 1 percent. As I have stated earlier, the rate of change in the CPI may temporarily be around zero or even slightly negative in the short run depending on developments in the prices of crude oil. Also, it is possible that the sensitivity of prices to higher rates of domestic resource utilization may have been reduced due to the progress of economic globalization. Meanwhile, a fall in crude oil prices may contribute to the continuing economic expansion, since it would improve Japan's terms of trade, thus boosting real wages and private consumption. What is important in terms of the forward-looking monetary policy is the basic trend of inflation. Under the assumption that overseas economies are to continue their expansion and that the growth mechanism underpinning the domestic economy is firmly maintained, trend increases in the CPI are likely to take hold in the long run, as the influence of declining crude oil prices fades. In any event, it is important to make an effort to achieve price stability in the medium to long term based not on shortterm fluctuations in prices but on forecasts for the economy and prices from a sufficiently long-term perspective. There has been criticism that dialogue between the Bank and financial markets has not been smooth. Central banks need to carefully explain to market participants and the public the basic thinking behind their monetary policy conduct and their assessment of the economic and financial situation. Through careful explanation of these two points, not only will the transparency of monetary policy conduct be ensured but the effectiveness of the policy will be enhanced. 4 Market participants form expectations regarding future interest rates by adjusting their views on the economy and prices on the basis of information provided by the central bank. Meanwhile, central banks deduce market participants' views on the economy and prices from movements in market It is important for the "understanding of medium- to long-term price stability" to become common knowledge among market participants as well as among Policy Board members, and be a focal point in terms of communication policy, as this will in turn facilitate consensus-building among the public. For more details, see K. Iwata and M. Fukao, "Keizai Seido no Kokusaiteki Chosei (International Adjustment of Economic Systems)," Nihon Keizai Shimbun, Inc., 1995. On the subject of the Bank of England's policy regarding communication between itself and financial markets, Governor Mervyn King, in his speech, said that central banks should provide markets with two key pieces of information -- the objective of monetary policy and the central banks' analysis of and outlook for the economy -- to facilitate the formation of market expectations regarding the path of future policy rates. However, he disapproved of providing direct hints about the path of interest rates, since the results of specific policy decisions regarding interest rates remain unknown until after voting within the policy committee has taken place. For details, please refer to the speech by Mervyn King, Governor of the Bank of England, at the Lord Mayor's Banquet for bankers and merchants of the City of London at the Mansion House on June 21 2006. interest rates or shifts in the yield curve. Dialogue with markets thus constitutes a two-way exchange of information. The key point here is that central banks provide information concerning the basic direction of monetary policy but do not specify the timing of an actual policy change. At an MPM, the Policy Board members discuss the current and future state of the economy and prices based on the latest data and information to have become available by the time of the meeting. It is therefore impossible to inform markets of the timing of the policy change in advance. Even if it were possible to do so, the result would be to deprive the Bank of the benefit of information that it could have gleaned from markets. It is desirable that dialogue between the Bank and markets be left to take place as free as possible from noise and distortion.
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Summary of a speech by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, at the Keizai Club, Tokyo, 4 April 2007.
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Toshiro Muto: Outlook for economic activity and prices and the conduct of monetary policy in Japan Summary of a speech by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, at the Keizai Club, Tokyo, 4 April 2007. * * * Introduction Today I would like to talk about the recent state of the economy and prices, as well as to explain the basic framework of, and thinking behind, the Bank of Japan's conduct of monetary policy, including the reasoning behind the policy adjustment at its Monetary Policy Meeting (MPM) in February. I. The economy and prices – current situation and outlook A. Overseas economic developments Let me start with the current state of overseas economies and their future outlook. In the United States, the pace of economic growth has been decelerating, mainly reflecting adjustments in the housing market. So far, however, the influence of the adjustments in the housing market on the economy has been limited. Labor market conditions remain tight, with a marginal slowdown in employment gains. In this situation, the pace of deceleration in private consumption has been moderate, supported mainly by an increase in household income. Developments in the U.S. corporate sector are generally firm, since profits remain at high levels and business fixed investment, although decelerating somewhat, is maintaining its uptrend. With regard to housing finance, some people voice concern that the delinquency rate for mortgage loans to subprime borrowers (those with relatively low credit standing) has been rising recently, but the prevalent view is that this is unlikely to pose a threat to the overall economy or the financial market because the share of subprime loans in overall mortgage loans is not very large. Nevertheless, given that the likely extent of future adjustments in the housing market is still uncertain and the core consumer price index (CPI) continues to increase at a relatively rapid pace, attention should be paid to both the downside risk of a further economic slowdown and the upside risk of inflation. Taking all available data for the U.S. economy and prices into account, however, the economy is likely to realize a soft landing – that is, after experiencing a moderate slowdown for a while it will move onto a path of stable growth, at a rate near its potential, as adjustments in spending in the household sector abate. In the euro area, economic recovery continues to be solid, since the increase in production and improvement in corporate profits have led to recovery in business fixed investment and private consumption. In Germany, the value-added tax rate was increased in January this year. This precipitated some last-minute rises in the consumption of certain products, which subsequently fell back again, and since January has also pushed up consumer prices to some extent; however, it has not so far had a significant impact on either consumption or any other part of the economy. In China, both domestic and external demand continue to expand strongly, and the NIEs and ASEAN economies continue to expand at a moderate pace on the whole. Taking these developments into account, overseas economies as a whole are likely to continue to expand, with some possible slowdown in the U.S. economy offset by expansion elsewhere. With the plunge in the Shanghai stock market at the end of February, stock prices worldwide declined substantially. In corporate bond markets in the United States and Europe, for example, there was some reassessment of credit risk, as seen in wider credit spreads between government bonds and corporate bonds, especially those with low credit ratings. In foreign exchange markets, the yen appreciated against the U.S. dollar. In May-June 2006, there was a worldwide adjustment in financial markets, the so-called "global risk reduction," but this was followed by an upturn in stock prices, a narrowing of credit spreads on corporate bonds, and a depreciation of the yen, all of which lasted up until the end of February. The most recent adjustments can be considered as an unwinding of investments made during this period. Global investors' stance toward risk-taking may have become more assertive in the wake of their success in dealing with the global risk reduction as well as the relatively modest volatility in financial markets seen subsequently. This more assertive risk-taking behavior seems to have been modified in response to the plunge in Chinese stock prices and the release of some weak data on the U.S. economy. As I have mentioned, there has been no significant change in the fundamentals of the global economy, but we will continue to pay close attention to developments in financial markets and any possible implications for economic activity. B. Economic developments in Japan Against the background of the strong growth in overseas economies, Japan's economy has been experiencing a sustained period of moderate expansion. The current economic expansion, which started in January 2002, is now in its sixth year. 1. Developments in the corporate sector Reflecting the expansion of overseas economies, Japan's exports are likely to continue to increase. Business fixed investment is also expected to keep increasing on the back of strong corporate profits and steady demand at home and abroad. This favorable situation in the corporate sector is confirmed by the latest March Tankan (Short-Term Economic Survey of Enterprises in Japan). Survey results in the March Tankan suggest that firms as a whole have made upward revisions to their projections for current profits for fiscal 2006 from the forecasts reported in the December Tankan. They are expecting profits for fiscal 2006 to have increased by 6.2 percent from the preceding fiscal year, posting a fifth consecutive year-on-year increase. Ratios of current profits to sales exceeded the levels posted during the period of the bubble economy. The results for business fixed investment suggest that firms on aggregate are expecting their capital investment for fiscal 2006 to have grown by 9.5 percent from a year earlier, its fourth consecutive year of growth. Business fixed investment planned for fiscal 2007 is also at a relatively high level for the time of year, namely, the turning point in the fiscal calendar. It seems, however, that firms, seeking to boost production capacity so as not to miss the opportunity to increase profits in the global market, are maintaining their cautious scrutiny regarding the profitability of individual investment projects, having become more exposed to the discipline of the capital market. Against this background of growth in domestic and external demand, production is on an upward trend. Although production has been decreasing somewhat since January, this is largely due to a downward reaction to the high growth posted in the October-December quarter of 2006 as a result of increased automobile production. On average, production has been increasing by around 1 percent quarter on quarter. Inventories have been more or less in balance with shipments in the industrial sector as a whole, but inventories of electronic parts and devices have been at elevated levels since the second half of 2006 due mainly to accelerated production leading up to new product releases. Although strong demand for IT-related goods is likely to prevent sharp adjustments in inventories, attention should continue to be paid to developments in inventories of IT-related products as the pace of increase in global production capacity in this sector is rapid. These positive developments in the corporate sector are reflected in firms' view of business conditions. Although the diffusion index for business conditions in the March Tankan registered a slight decline relative to the previous Tankan, on the whole it is still at a favorable level considering the adjustments that have been occurring in the financial market. 2. Developments in the household sector The positive influence of the strength in the corporate sector has been feeding through into the household sector at a moderate pace. The number of employees continues to increase steadily. A closer look reveals that not only the number of part-time workers but also that of full-time employees is rising. A survey conducted by a private institute earlier this year indicated that more new graduates would be hired by firms in fiscal 2007 than in the previous year. Despite the strength in the corporate sector, however, it is often said that households are not getting a real sense that the economy is expanding, and this seems to be related to the wage situation. To be more specific, the increase in nominal wages per worker, which had been only moderate, has recently appeared to stagnate. Regular payments are particularly weak, remaining somewhat beneath the level recorded last year. The sluggish growth in wages despite continued high corporate profits seems attributable to persistent labor cost restraint by firms, which feel the need to be more profit-conscious amid intensifying global competition and greater exposure to the discipline of the capital market. Moreover, employees' preference for stable employment over a wage increase after their past experiences of a severe employment situation, as well as the retirement of baby-boomers whose wage levels are relatively high, are also thought to share responsibility for the recent weak growth in nominal wages per worker. Meanwhile, firms are increasingly feeling shortages of labor as shown in the March Tankan. If the number of employees keeps increasing while growth in the population of those aged 15 and over peaks out, upward pressure on wages should be expected to increase over time. Although the focus of attention tends to be the weak growth in regular payments, the positive influence of the strength in the corporate sector should not be overlooked, as this is now feeding into the household sector via various channels, such as increases in the number of employees, the wages of part-time and temporary workers, and dividends. Although the pace at which the positive influence of the corporate sector has been filtering through into the household sector has been somewhat subdued, the gradual increase in household income is expected to continue, supported, for example, by growth in the number of employees on the back of continued high corporate profits. With household income increasing gradually, private consumption has been firm recently. In summer 2006, private consumption declined temporarily due to unfavorable weather conditions and consumers' reluctance to buy before the introduction of new products; then from the autumn onward, sales at department stores and supermarkets were weak, weighed down by sluggish sales of winter apparel due to the unseasonably warm weather. However, sales data released since the turn of the year have been favorable, and sales of spring apparel seem to be strong. Sales of electrical appliances are showing clearer upward momentum recently, with sales of digital appliances such as flat-panel TVs and new game consoles growing steadily. As for services consumption, sales in the food service industry and outlays for travel have generally been firm. Looking forward, although unlikely to post substantial gains, private consumption is expected to be on a gradual uptrend, reflecting increases in household income. In sum, in fiscal 2007 Japan's economy is likely to continue to experience a sustained period of growth at a pace slightly higher than its potential, with the virtuous circle of production, income, and spending remaining intact. If this turns out to be the case, our economy will have been growing at around 2 percent per annum since fiscal 2003. Such a sustained period of growth at a rate above the economy's potential, even though it coincides with a period of fiscal consolidation, is due to the strong expansion of overseas economies and the accommodative financial environment. 3. Developments in prices I would now like to talk about the price situation. Recent price developments in Japan have been considerably influenced by past falls in the prices of crude oil and other international commodities. Crude oil prices have been experiencing declines since August last year, dropping sharply at the start of this year due to the unseasonably warm winter in the United States. Since then, however, they have bounced back somewhat, reflecting factors such as a cold spell in North America, the U.S. policy decision to increase its strategic petroleum reserve, and geopolitical risks, thus displaying some considerable fluctuation. Prices of nonferrous metals, meanwhile, declined up to and during early 2007 within elevated levels, with the decline most notable in copper. Recently, however, they have started to bounce back. Reflecting the fall in international commodity prices, domestic corporate goods prices have been somewhat weak recently. In the short run, they are expected to be somewhat weak or flat, again due to the fall in international commodity prices. As for consumer prices, the year-on-year rate of increase in the CPI (excluding fresh food, on a nationwide basis) has been decelerating since autumn 2006, and the most recent data indicated that in February the CPI declined by 0.1 percent from a year earlier, posting negative growth for the first time since April 2006. The sluggishness is largely attributed to developments in the prices of petroleum products, such as gasoline, which have recently declined from their levels the previous year, following a period of deceleration. In addition to this, the introduction of new billing plans for cellular phones has also been placing downward pressure on the CPI recently. Judging from the basic environment surrounding prices, however, greater upward pressure on prices is expected. According to survey results reported in the March Tankan, the share of firms experiencing a shortage of production capacity exceeds the share of those feeling excess, and corporate managers are increasingly feeling shortages of labor. In this situation, resource utilization rates are rising steadily, and estimates of the output gap continue to be positive. Furthermore, downward pressure on prices from unit labor costs (labor costs per unit of output) is expected to weaken as the upward trend in wages becomes more distinct. In view of these developments in the underlying price environment, the CPI is expected, in the longer run, to trend upward. Nevertheless, it should be borne in mind that there are also downside risks, which could, if they materialize, make it harder for prices to swiftly regain an upward trend: an example is the progress of economic globalization, which may cause prices to respond less sensitively to changes in the output gap than hitherto, and cause wages to take longer to establish their recovery than projected. II. Conduct of monetary policy A. Framework for the conduct of monetary policy On the basis of this outlook for the economy and prices, the Bank decided on a policy adjustment at its MPM in February. The policy adjustment was decided in line with the framework for the conduct of monetary policy introduced in March 2006 and was the second such adjustment based on this framework, the first being the decision to bring to an end the zero interest rate environment in July 2006. Let me explain the outline of the framework before elaborating on the background for the policy adjustment in February. The framework was introduced in March 2006 at the time the Bank terminated the quantitative easing policy and reinstated a policy of interest rate control. It consists of three elements. The first is to clarify what constitutes "price stability"; the second, to employ two perspectives for assessing the economic and price situation; and the third, to outline the Bank's thinking on the future conduct of monetary policy. Let me explain each element in turn. With respect to "price stability," the stated objective of monetary policy, the Bank interprets this to mean "a state where various economic agents such as households and firms may make decisions regarding such economic activities as consumption and investment without being concerned about the fluctuations in the general price level." Furthermore, we have disclosed the amount of inflation that members of the Policy Board understand, when conducting monetary policy, as being consistent with price stability over the medium to long term. This is released as the members' "understanding of medium- to long-term price stability." Expressed in terms of the rate of year-on-year change in the CPI, this "understanding" takes the form of a range, between around 0 and 2 percent, with most members' median figures falling on one side or the other of 1 percent. It is this understanding of price stability that members have in mind when making monetary policy decisions. The "understanding of medium- to long-term price stability" could change gradually in response to structural changes in the economy, such as progress in economic globalization and in information and communication technology. Therefore, the Bank will, in principle, review it annually. The second element is the employment of two clearly defined perspectives for assessing economic activity and prices when making policy decisions. From the first perspective, we will examine the prospects for economic activity and prices for one to two years ahead, assessing whether the most likely outlook is for the economy to follow a path of sustainable growth under price stability. Note that the focus is on the outlook. This is because it takes considerable time for monetary policy actions to filter through into the economy and prices. It is necessary, therefore, to conduct monetary policy in a forward-looking manner, taking into account expected economic and price developments. The key to achieving this is to establish what is the most likely outlook. The Bank thus produces a forecast for the economy and prices for about one and a half to two years ahead and publishes it in the April and October issue of its Outlook for Economic Activity and Prices (hereafter the Outlook Report). Also at each MPM, we look to update our picture of the most likely outlook by carefully analyzing incoming data and other fresh information. In this sense, the careful analysis of incoming data, in other words, being data dependent, does not contradict the idea of forward-looking monetary policy; rather, it constitutes a necessary ingredient. Although we take the utmost pains when performing our analysis, any forecast entails a degree of uncertainty. In conducting monetary policy, it is necessary to consider the possibility that our most likely outlook for the economy and prices will not in fact materialize and to calculate the costs that this would entail, as well as to examine risk factors that may influence the economy and prices in the medium to long term, in other words, outside of the projection period. The second perspective, therefore, involves examining, over a longer horizon, the various risks that are most relevant to conducting monetary policy aimed at realizing sustainable growth under price stability. Since the second perspective looks at areas that are not covered in the first perspective, the two perspectives are complementary in nature. Moreover, our assessments are always based on both perspectives. Note, therefore, that it is not the case that policy decisions are based or rely heavily on one or the other of the two perspectives, depending on the circumstances. The third element is to outline, based on the above assessments, the Bank's thinking on the future conduct of monetary policy and to publish this in the Outlook Report. B. The policy adjustment in February At the February MPM, the decision to raise the policy interest rate was taken after reviewing the economy and prices and assessing them from our two complementary perspectives, as I have described. First, considering the prospects for the Japanese economy from the first perspective, we carefully analyzed various economic data released since the January MPM in addition to all relevant information available prior to it. On the basis of this careful analysis and discussion at the MPM, we came to the conclusion that the economy was likely to continue to experience a moderate expansion with a virtuous circle of production, income, and spending in place. As referred to earlier, the world economy continues to expand, with growth more balanced as regional economies gain momentum. Indeed, this was the consensus view among delegates at the G-7 meeting in February. Domestically, newly available figures for the fourth quarter of 2006 indicated that business fixed investment was increasing on the back of high corporate profits. The sluggishness in private consumption seen last summer was judged a merely temporary phenomenon, and a gradual increasing trend was reaffirmed. Meanwhile on the price front, it was considered that the year-on-year rate of change in the CPI (excluding fresh food) might register around zero in the short run, depending, for example, on developments in the prices of crude oil. However, in the longer run, the CPI was judged likely to trend upward given increased resource utilization and the expected continuation of economic expansion. In other words, taking a forward-looking perspective on the economic and price situation for one to two years ahead, prices were judged likely to trend upward given the fundamentals behind the economy and prices, even if the rate of change in the CPI might temporarily fall into negative territory in the short run. Considering this forecast for the economy and prices in the light of the Bank's "understanding of medium- to long-term price stability" referred to earlier, it was likely that sustainable growth under price stability would be achieved. This outlook is based on the assumption that private economic agents such as market participants and firms make decisions on economic activity by factoring in, to some extent, future policy changes. Thus, with prospects for the economy and prices improving, gradually adjusting the level of the policy interest rate as these anticipated improvements come to pass will facilitate the smooth realization of the outlook's favorable predictions and lead in turn to a long-lasting economic expansion. Second, turning to the longer horizon of the second perspective and examining the various risks most relevant in conducting monetary policy, it appeared likely that, with the prospects for the economy and prices improving, the stimulative effects of monetary policy would increase if the policy interest rate were left at its recent level. If the expectation were to take hold, in such a situation, that interest rates would remain low for a long time regardless of developments in economic activity and prices, then economic agents such as financial institutions and firms would behave accordingly. The result could well be a misallocation of resources in the long run as agents became over-extended in financial markets or poured funds and other resources into inefficient economic activities. This could then interfere with the sustained economic expansion. In the October Outlook Report, this was deemed one of the risk factors whose materialization, although not necessarily probable, would involve sufficient economic costs that it should be considered a "relevant" risk in conducting monetary policy. I must emphasize, however, that this risk factor involves a putative future scenario; it does not describe a situation that has already emerged. Picking up on the Bank's concern with this risk factor, some market participants have seen the recent policy action as an attempt to exert direct influence on the foreign exchange rate and yen carry trade. However, considering the substance of the Bank's thinking, as I have explained it earlier, makes it clear that this is not the case. Monetary policy is conducted with the aim of steering the Japanese economy toward sustainable growth under price stability, and careful examination of the economy and prices is carried out with this aim in mind. The Bank's basic view is that developments in financial markets, including the foreign exchange market, are factors that may influence economic activity and prices and it is in this capacity that they come to the attention of monetary policy. At the February MPM, the Bank judged that for the economy and prices to follow a desirable path, we had reached an appropriate juncture to adjust the level of the interest rate. The operating target of the policy interest rate (the uncollateralized overnight call rate) was therefore raised from around 0.25 percent to around 0.5 percent. At the same time, the basic loan rate applicable under the complementary lending facility was raised from 0.4 percent to 0.75 percent, widening the interest rate differential between the basic loan rate and the operating target of the uncollateralized overnight call rate from 0.15 percent to 0.25 percent. The interest rate under the complementary lending facility serves as an upper limit on the overnight call rate. When the interest rate differential between the interest rate under the complementary lending facility and the operating target of the call rate is small, the call rate tends to diverge less from its target, but the free formation of market interest rates is restricted. In view of the stability of the call rate since the zero interest rate environment was brought to an end in July last year as well as the gradual recovery in the functioning of the money market, it was judged that some widening of the interest rate differential will not hamper smooth interest rate control. C. The conduct of monetary policy in the near future With regard to the future course of monetary policy, the Bank intends, as previously stated, to "adjust the level of interest rates gradually in the light of developments in economic activity and prices, while maintaining the accommodative financial conditions ensuing from very low interest rates for some time." Actual policy actions will be decided through careful analysis of the prospects for the economy and prices, and thorough discussion among Policy Board members at each MPM. As we have repeatedly stated, we do not have a predetermined schedule regarding the future policy actions. We have often been asked by market participants and the press whether this process of gradual interest rate adjustment should be regarded as "normalization." The term "normalization," however, carries various meanings. If the term "normalization" is being used to imply that interest rates are adjusted toward a particular so-called "neutral" level in line with a predetermined schedule, then we should make clear that we have no such intention. The Bank's approach to the conduct of monetary policy, as I have previously stated, is to keep accommodative financial conditions ensuing from very low interest rates for some time, and to adjust the level of interest rates gradually in the light of developments in economic activity and prices. The views of all members are entirely consistent on this point. Therefore, adjustments in the level of interest rates will be carried out in the light of developments in economic activity and prices, and not in line with any predetermined schedule. If the term "normalization" can be used to describe such a process, then perhaps it would be fair enough to say that we will be adjusting the level of interest rates gradually in light of the "normalization" of economic activity and prices. In any event, we think the least misleading option is for our basic thinking stated in the Outlook Report and in the press release accompanying the February policy action to be read exactly as stated. D. Communicating with the market In connection with the February policy change, there is criticism that there may have been some confusion in the process of communicating with the market since the end of last year when the policy action began to be the target of speculation. We accept such criticism and will try to improve the means of communication in the future. It may be productive, at this point, to summarize our approach to communication between the central bank and markets. Since monetary policy takes effect through financial markets and the behavior of financial institutions, ensuring its transparency is important not only in terms of accountability to the general public but also to improve the policy's effectiveness. Monetary policy needs to be transparent both with regard to the policy content and with regard to the means of conveying this content to the public. In terms of the latter, the Bank has employed various communicative media, such as the Outlook Report, the Monthly Report of Recent Economic and Financial Developments, the minutes of the MPMs, and press conferences, all of which can be easily accessed by the general public. As far as the contents of the policy itself are concerned, we believe there are two key pieces of information that the central bank needs to provide: the central bank's assessment of the economic and price situation; and its basic thinking on the conduct of monetary policy. Market participants can form expectations regarding future interest rates by adjusting their views of the economy and prices on the basis of such information, while central banks can deduce market participants' views regarding the economy and prices from market interest rates and yield curves. What we have in mind in terms of communicating with the market is such a two-way exchange of information. Hinting at the actual timing of the policy change is generally inadvisable. If such a hint were made, market participants would carry out transactions based not on their own views of the economy and prices but in response to the Bank's hint, and this would result in a breakdown of the two-way exchange of information. Furthermore, at many central banks, including the Bank of Japan, policy decisions are made after thorough discussion among members of the policy meeting, culminating in a vote. In the absence of such discussion, to indicate whether or not a policy change will take place or to set a particular schedule for policy changes is inconceivable. Based on such an understanding of communication between the central bank and the markets, the Bank will stick closely to its principle of carefully explaining to the public its assessment of the economy and prices, and its basic thinking regarding the conduct of monetary policy. Meanwhile, to further facilitate meaningful communication with the market, we trust that the Bank's understanding in this regard will be widely recognized by market participants. Concluding remarks I have discussed the outlook for economic activity and prices, and our basic thinking on the conduct of monetary policy along with some issues related to communication with the market. The Bank will publish a new Outlook Report later this month in which our projections for the economy and prices up to fiscal 2008 will be released. In addition, the "understanding of medium- to long-term price stability" will come up for its first annual reexamination since the introduction of the "New Framework for the Conduct of Monetary Policy." The Bank will take advantage of such opportunities to further refine this framework and will continue to contribute to the achievement of sustainable economic growth under price stability through the appropriate conduct of monetary policy.
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Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, to the Naigai Josei Chousa Kai (Research Institute of Japan), Toyko, 10 May 2007.
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Toshihiko Fukui: The outlook for Japan’s economy and the conduct of monetary policy Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, to the Naigai Josei Chousa Kai (Research Institute of Japan), Toyko, 10 May 2007. * * * Introduction In the year since I last spoke to you here, Japan's economy has continued to expand moderately. Semiannually in April and October, the Bank of Japan explains its projection for the nation's economy in its Outlook for Economic Activity and Prices, or the Outlook Report for short. In the latest Outlook Report, which was released at the end of April, the Bank projected that from fiscal 2007 through fiscal 2008, the economy is likely to continue its sustained expansion, growing at a rate slightly above its potential. Today, I will focus on the Bank's view concerning developments in economic activity and prices based on the projection in the Outlook Report, and I will also explain the basic thinking regarding future monetary policy conduct. I. Developments in overseas economies I would first like to touch upon developments in overseas economies, which form the basis for the Bank's outlook for Japan's economy. Overseas economies taken as a whole continue to expand, with momentum being gained across a wide range of economies, and are likely to keep expanding. In the United States, although the pace of economic growth has recently been decelerating due mainly to ongoing adjustments in the housing market, the economy is likely to realize a soft landing and move onto a growth path at a rate near its potential as adjustments, particularly in household spending, become less severe. In the euro area, economic recovery has been solid, as the increase in production and improvement in corporate profits have led to recovery in business fixed investment and private consumption. Looking at East Asia, the Chinese economy continues to expand strongly with both exports and business fixed investment showing high growth, and the NIEs and ASEAN economies continue to expand at a moderate pace on the whole as domestic demand remains firm, despite a lull in exports. It was also the consensus view among delegates at the G-7 meeting in April that the global economy continues to expand robustly and is becoming more balanced. II. Current situation of Japan's economy Against the background of the generally favorable developments in overseas economies, Japan's economy has continued to expand moderately. Although exports to the United States are somewhat weak, overall exports continue to increase steadily reflecting the expansion of overseas economies. Business fixed investment continues to increase as corporate profits remain high. Production decreased in the January-March quarter of 2007 in reaction to the high growth in the previous quarter led by production in automobile-related goods, but it seems to be on a trend of 1 percent quarter-onquarter growth. As for the household sector, although growth of wages per worker has been somewhat sluggish due mainly to weak regular payments, employee income has continued to rise moderately supported by the increase in the number of employees. Property income such as dividends is also increasing. In this situation, growth in private consumption has recently resumed its upward movement, after sluggish growth over the summer of 2006 due to unfavorable weather conditions and consumers' reluctance to buy before the introduction of new products. In sum, although the pace of improvement in the household sector has been somewhat slow relative to the strength in the corporate sector, Japan's economy as a whole is expanding moderately. On the price front, domestic corporate goods prices have recently been about the same as their levels of three months earlier. The year-on-year rate of change in the consumer price index (CPI) excluding fresh food has recently been around 0 percent due to the drop in crude oil prices. III. Characteristics of the current economic expansion Let me now review the characteristics of the current economic expansion, in order to project the future course of the economy. The economic recovery began in January 2002, and its most distinctive feature is that the economy has been growing amid rapid globalization. Japanese firms – which have regained competitiveness as adjustment of excesses in production capacity, employment, and debt proceeds – have been increasing exports, against the background of global economic expansion and growing prevalence of international division of the production process. They have increased exports of a wide variety of goods – including capital goods and parts, automobiles, IT-related goods, and consumer goods – to an increasing number of countries. This strong performance of Japanese firms in the global market has led them to expect higher demand growth, thus accelerating business fixed investment. Economic growth achieved in this way has affected the distribution of the profits of economic growth to households. Faced with intensifying global competition and greater exposure to the discipline of the capital market, firms have changed the way they distribute profits. In an ever-changing competitive environment, they have been constraining increases in fixed costs and thus have continued to be cautious about increasing wages, particularly regular payments. Meanwhile, employees, having experienced a severe employment situation and currently facing intensifying global competition, have tended to prefer stable employment to a wage increase. Wage growth has therefore remained moderate despite the continuing high corporate profits. Nonmanufacturing firms, which have relatively little access to the global market, are also experiencing a severe market environment. In the nonmanufacturing sector, not only has deregulation led to increased supply with new entrants into the market, but also the decline in public expenditure has reduced demand. Given that changes in wages have become more closely linked to the level of corporate performance, the pace of increase in wages has been slower among nonmanufacturing than among manufacturing firms, reflecting their lower profits. In order to maintain competitiveness in the severe market environment, firms have continued to restrain labor costs. As a result, the pace of recovery in the household sector seems to be slower than people's expectations, despite the strength in the corporate sector. These features of the current economic expansion may also be affecting the environment surrounding prices. As firms have been restraining wages and also increasing productivity, upward pressure on prices seems to have been contained. Also, given that the driving force of current economic growth has been the corporate sector, especially globally active firms, and that the positive influence of the strength in the corporate sector has been relatively slow in feeding through into the household sector, supply and demand conditions for consumer goods and services are likely to improve more slowly than overall supply and demand conditions. In other words, while, from the demand side, growth in consumer demand is likely to be moderate given the slow pace of the flow of income from the corporate sector to the household sector, supply is likely to increase given the rise in imports due to economic globalization coupled with new entrants coming into the market as a result of deregulation. Looking at firms' perception of resource utilization, an indicator for supply and demand conditions, the weighted average of the diffusion indices of production capacity and employment conditions in the Tankan (Short-Term Economic Survey of Enterprises in Japan) suggests that the pace of improvement in resource utilization in consumption-related industries, such as retailing and services, is slower than the average for all industries. In recent years, the sensitivity of consumer prices to a rise in the utilization of resources such as production capacity and labor, or to changes in the output gap, has been declining, and this seems to have been due not only to deregulation and technological innovation but also to economic globalization. Another characteristic of the current economic expansion is that the financial environment has continued to be extremely accommodative, and this has been supporting private demand. This accommodative financial environment, together with the expansion of the global market and the progress in adjustment of excess production capacity mentioned earlier, has also underpinned the increase in business fixed investment. Interest rates have been very low relative to economic activity and price conditions. For instance, comparison of the real GDP growth rate with the real short-term interest rate – although the latter varies depending on how the expected inflation rate is estimated – shows that while the GDP growth rate has been around 2 percent, the real short-term interest rate has been in the range of around 0-0.5 percent if the actual year-on-year change in the CPI is used as the expected inflation rate. The lending attitudes of financial institutions have been positive reflecting expansion of risk-taking capacity as a result of improvement in their financial condition, and in this situation, the amount outstanding of lending by private banks has been increasing. In sum, the financial environment continues to be accommodative, both in terms of interest rates and availability of funds. The yen in terms of the real effective exchange rate has been moving at around its lowest level since the 1985 Plaza Accord, and this has been supporting growth in Japan's exports. Increases in asset prices, such as a more widely observed upturn in land prices, particularly in major cities, also seem to be exerting upward pressure on private demand. IV. Outlook for Japan's economy Next, I would like to elaborate on the outlook for Japan's economy based on the assessment of the current economic situation that I have described. From fiscal 2007 through fiscal 2008, Japan's economy is likely to continue its sustained growth of around 2 percent, somewhat above its potential. Given that the expansion of the global market and the accommodative financial environment – the two distinctive features of the current economic expansion – are likely to continue, the virtuous circle of production, income, and spending is expected to remain intact. In the corporate sector, business fixed investment is expected to keep increasing as exports continue to rise and corporate profits remain high. According to the March Tankan, firms' business fixed investment plans for fiscal 2007 are strong for initial estimates. As for the household sector, household spending is expected to follow a moderate upward trend as the positive influence of the strength in the corporate sector feeds through into the household sector slowly but steadily. Although firms are likely to continue to restrain labor costs, upward pressure on wages is likely to increase gradually as firms feel a growing shortage of labor. In fact, wages for temporary and part-time workers are rising, and an increasing number of firms are planning, for the first time in many years, to raise their starting salaries for new graduates. In this spring's wage negotiations, labor unions demanded slightly larger wage increases than hitherto and firms' management tended to accommodate them, at least to a certain extent. Firms may become more eager to hire or retain skilled workers in order to maintain and enhance their quality control expertise and their ability to provide value-added goods and services, both of which will give them a competitive edge in the long term. Acceleration in wage growth, coupled with the ongoing rise in the number of employees, will likely lead to a more firmly established uptrend in employee income. Property income of households is also expected to continue to increase due mainly to the rise in dividends, since households have been increasing their investments in financial instruments such as stock investment trusts. Furthermore, how baby boomers, who have started to retire, will spend their retirement benefits and savings should be watched closely. Thus, private consumption is likely to follow a moderate upward trend as the positive influence of the strength in the corporate sector feeds through into the household sector via various channels. In this situation, the environment surrounding prices is expected to gradually improve. If the economy continues to grow at a rate exceeding its potential for the next two years, the rate of utilization of resources such as production capacity and labor will further increase. In other words, the output gap will continue to indicate tighter supply and demand conditions. As the strength in the corporate sector leads to further increases in employee income, it is natural to expect that supply and demand conditions for consumer goods and services will improve and that this will exert upward pressure on consumer prices. Moreover, unit labor costs (labor costs per unit of output), although currently still declining with the growth rate of wages hovering around 0 percent, are likely to stop falling and start showing modest increases reflecting gradual rises in wages. Although inflation expectations in the private sector have shifted down due mainly to past falls in the prices of petroleum products, prices in general are still expected to increase moderately. Taking these developments into account, the year-on-year rate of change in the CPI is likely to be around 0 percent in the short run depending on developments in crude oil prices, but is expected gradually to rise in the longer run. However, the pace of increase is likely to be moderate, given that the sensitivity of prices to changes in the output gap is declining due to factors such as economic globalization and deregulation. The year-on-year rate of increase in the CPI is expected to be slightly above 0 percent in fiscal 2007 and around 0.5 percent in fiscal 2008. V. Upside and downside risks to the outlook for economic activity I have so far outlined the most likely projection for the next two years or so. However, the economy constantly faces various risks, and due attention should be paid to the possibility that economic activity and prices might deviate from this projection should particular risks materialize. In the April 2007 Outlook Report, we pointed out the following as upside and downside risks to the outlook for economic activity: developments in the global economy; supply and demand conditions for IT-related goods; and possible larger swings in financial and economic activity. Let me elaborate on each risk. The first risk concerns developments in the global economy, which is expected to keep expanding with momentum being gained across a wide range of economies. In the United States, adjustments in the housing market, including problems in the market for subprime mortgage debt, are still ongoing, and some leading indicators of business fixed investment have been showing somewhat weak developments. If adjustments in the housing market turn out to be greater than expected or business fixed investment weakens, economic growth may decelerate further. On the other hand, there is a risk that inflationary pressures in the United States may persist longer than expected, given that the rate of change in the core CPI has been somewhat elevated reflecting higher utilization of resources. If inflationary pressures do not subside, there is a risk that not only the U.S. but also the global economy and financial markets may be adversely affected, for instance, through the reaction of long-term interest rates and foreign exchange rates to this situation. In China, there is an upside risk of the economy growing faster than expected, particularly fixed asset investments and exports. Whether this risk can be reduced and the Chinese economy can realize stable growth even after the 2008 Olympic Games in Beijing should be the focus of attention. The second risk concerns supply and demand conditions for IT-related goods. Inventory adjustments of IT-related goods are continuing, and this seems to be the result mainly of specific domestic factors, namely, the slow improvement in the balance of inventories and shipments for electronic parts, particularly those related to cellular phones. Global demand for IT-related goods has so far been on an upward trend due partly to the rapid growth in emerging-market economies, such as the BRICs, and thus inventory adjustments should basically come to an end in or after the middle of 2007. However, if expected global demand is revised significantly downward in response to, for instance, a deceleration in the global economy, there is a possibility that adjustment pressures on inventories may intensify, since the pace of increase in global supply tends to be rapid in the IT-related sector. The third risk concerns possible larger swings in financial and economic activity based on optimistic assumptions regarding, for example, financial conditions. Japan's current economic circumstances, with the financial positions of both firms and financial institutions improving and real interest rates remaining very low, are such as potentially to encourage assertive financial and economic activity. As for foreign exchange rates, the real effective exchange rate is at the lowest level since the 1985 Plaza Accord, and the upward trend in land prices in major cities has become increasingly distinct as seen in the fact that commercial land prices in Tokyo and Osaka in March's Land Price Publication showed a double-digit increase from the previous year. These developments in foreign exchange rates and asset prices may also cause activity of both firms and financial institutions to accelerate. Should greater assertiveness be based on optimistic assumptions regarding future profitability, such as too rosy expectations for the growth rate, financing costs, foreign exchange rates, and asset prices, the result could well be a misallocation of resources in the long run as agents become over-extended in financial markets or pour funds and other resources into inefficient economic activities. Such behavior may push up economic growth and asset prices in the short run, but it can lead to later downward adjustments and hamper the sustainability of economic growth. VI. Upside and downside risks to the outlook for prices These upside and downside risks to the outlook for economic activity may affect prices if they should materialize, but there are also upside and downside risks unique to price developments that could cause prices to deviate from the projection. In the April Outlook Report, two risks are noted: uncertainty concerning the sensitivity of prices to changes in the output gap, and developments in the prices of crude oil and other commodities. The sensitivity of prices to changes in the output gap has been declining in recent years due partly to economic globalization. This tendency has been taken into account in the projection for prices mentioned earlier, but the sensitivity of prices may turn out to be lower than assumed in the projection. If, despite prolonged economic expansion, wage growth were to remain low relative to the pace of productivity gains, downward pressure on prices from labor costs would persist. Moreover, if the positive influence of the strength in the corporate sector feeds through into the household sector slower than expected due to sluggish wage growth, supply and demand conditions for consumer goods and services may not improve in line with the diminishing slack in the economy. In such a situation, prices may not be responsive to the improvement in the economic situation. On the other hand, if the economy continues to grow at a pace exceeding the potential through fiscal 2008, it is likely that the rate of utilization of resources such as production capacity and labor will rise further and the output gap will show further tightening of supply and demand conditions. Inflation expectation, which has been low and stable, may increase with higher resource utilization, particularly in labor. Moreover, although firms are likely to continue to restrain labor costs, they may change their attitude with the aim of hiring or retaining skilled workers. These potential changes would exert upward pressure on prices. Prices of crude oil and other international commodities may deviate either upward or downward from the projection depending on factors such as geopolitical risks. Close attention should be paid to developments in these prices, since they will have a substantial effect on domestic corporate goods prices and consumer prices. VII. Conduct of monetary policy Let me now explain how the Bank will conduct monetary policy based on the outlook for the economy and prices I have outlined, giving due regard to the possibility of upward or downward deviation. In March 2006, when the quantitative easing policy was terminated, the Bank introduced the "New Framework for the Conduct of Monetary Policy." It consists of three elements. The first is releasing the "understanding of medium- to long-term price stability," the second, assessment of the economic and price situation from two perspectives taking account of the "understanding of medium- to long-term price stability," and the third, outlining the Bank's thinking on the future course of monetary policy. The "understanding of medium- to long-term price stability" is the level of inflation that each member of the Policy Board understands, when conducting monetary policy, as being consistent with price stability over the medium to long term. Each member, with this understanding in mind, judges whether Japan's economy will achieve sustainable growth under price stability, and makes policy decisions based on this judgment. At the Monetary Policy Meeting at the end of last month, we conducted a review of the "understanding," in accordance with the decision that it should be reviewed, in principle, annually. First, the basic understanding concerning price stability was reviewed, and it was reaffirmed as follows. Price stability is a state where various economic agents including households and firms may make decisions regarding economic activities without being concerned about fluctuation in the general price level. Given that the effects of monetary policy take time to work through the economy and that the volatility of output may actually be amplified when attempts are made to absorb every shortterm change in prices resulting from various shocks, the Bank should forecast developments in economic activity and prices from a sufficiently long-term viewpoint and strive to realize price stability over the medium to long term. Furthermore, in examining the "understanding of medium- to long-term price stability," the following points were considered. First, the significance of measurement bias in the CPI. Second, the necessary extent of the "safety margin" that acts as a buffer against the risk of falling into a vicious circle of declining prices and deteriorating economic activity. And third, possible changes in the level of inflation perceived by households and firms as consistent with price stability. As for the first point, it seemed that measurement bias remained insignificant even taking into account last year's rebasing of the CPI. Regarding the second point, the "safety margin," the risk of the economy falling into a deflationary spiral seems to have further decreased, since the strength of the corporate sector and robustness of the financial system have further improved. Finally, on the third point, the level of inflation perceived by households and firms as consistent with price stability is unlikely to have changed much, since changes in the inflation rate have been small. Based on these considerations, it was agreed, as was also the case a year ago, that the "understanding of medium- to long-term price stability" expressed in terms of the year-on-year change in the CPI, takes the form of a range approximately between 0 and 2 percent with most Policy Board members' median figures falling on one side or the other of 1 percent. The next step, the examination from two perspectives, involves assessment of the outlook for the economy and prices from two standpoints – whether the main scenario leads to the attainment of our objective and how other relevant risks should be evaluated. From the first perspective, we examine the prospects for economic activity and prices for one to two years ahead – this time, through fiscal 2008 – and assess whether the most likely outlook is for the economy to follow a path of sustained growth under price stability. Through fiscal 2008, the economy, as I said earlier, is likely to continue its sustained expansion with a virtuous circle of production, income, and spending in place. The year-on-year rate of change in the CPI (excluding fresh food) is likely to be around 0 percent in the short run, but is expected gradually to rise in the longer run. Such developments can be regarded as in line with the "understanding of medium- to long-term price stability" that each member of the Policy Board has in mind. In sum, we judged that, through fiscal 2008, Japan's economy is likely to realize sustainable growth under price stability. This outlook is based on the assumption that market participants and firms make decisions by factoring in future changes in monetary policy. Thus, adjusting the level of the policy interest rate will become necessary for the economy and prices to continue to follow the projection. The pace of necessary adjustment, however, will depend on the degree of future improvements in the economy and price situation. We do not, therefore, have any predetermined schedule. The second perspective extends the time horizon and assesses the risks considered most relevant to the conduct of monetary policy. In this assessment, we take account of the cost incurred should risks materialize, even though the probability of this happening may be low. In this regard, both upside and downside risks need to be borne in mind. In terms of the upside risks, we need to be mindful of the stimulative effect of monetary policy being further amplified with the improved prospects for economic activity and prices. If, for instance, the expectation takes hold that interest rates will remain low for a long time regardless of developments in economic activity and prices, then firms and financial institutions may over-extend themselves based on such expectation, resulting in medium- to long-term risks of larger swings in the economy and inflation rate, and of misallocation of funds and resources. On the other hand, if the downside risks mentioned earlier should materialize, the improvement in the economic situation may stall. It is also possible that prices will continue not to rise despite the improvement in economic conditions. Nevertheless, the risk of the economy falling into a vicious circle of declining prices and deteriorating economic activity seems to have further decreased, since the strength of the corporate sector and the robustness of the financial system have been enhanced. Based on this outlook and assessment of risks, we have decided to maintain the current basic thinking regarding the conduct of monetary policy, employed since the termination of the quantitative easing policy in March 2006. The Bank adjusted the level of the policy interest rate in July 2006 and in February 2007. Adjustments were made in view of the outlook for the economy and prices, with the Bank judging that sustained economic growth would continue with a virtuous circle of production, income, and spending in place, and that consumer prices would be likely to increase moderately in the long run in line with the "understanding of medium- to long-term price stability." Based on this assessment, we have been realizing the idea of "adjusting the level of interest rates gradually in the light of developments in economic activity and prices." With inflationary pressures weak, the pace of adjustment has been slow and the accommodative financial conditions ensuing from very low interest rates have been maintained. The Bank's basic thinking in this regard will remain the same in the conduct of future monetary policy. In sum, while confirming that Japan's economy remains likely to follow a path of sustainable growth under price stability in light of the aforementioned "understanding" and assessing relevant risk factors, the Bank will adjust the level of interest rates gradually in accordance with improvements in the economic and price situations. Concluding remarks Lastly, I would like to touch upon the Bank's communication of information concerning the conduct of monetary policy. The Bank will continue to explain carefully to the public its assessment of economic activity and prices and its basic thinking on the conduct of monetary policy in line with the "New Framework for the Conduct of Monetary Policy," through, for example, the Outlook Report. In relation to this point, there are voices that call for the Bank to communicate information on the specific time schedule of a policy change, but we neither believe it possible nor consider it appropriate to do so. The Bank considers that there are two key pieces of information that it should provide, namely, its assessment of economic activity and prices, and its basic thinking on the conduct of monetary policy. Taking into consideration such information provided by the Bank, market participants carry out transactions based on their views regarding economic activity and prices; the Bank in turn obtains information regarding market participants' views on economic activity and prices from interest rates formed in financial markets as a result of transactions carried out by market participants, and uses it in making its assessment of economic activity and prices. We think such a two-way communication process is important. If, however, the central bank were to indicate a specific time schedule for a policy change, market participants would carry out transactions based not on their own views regarding economic activity and prices but on the Bank's indication. Therefore, we think it is vital that the central bank's communication to the public should be limited to the extent I have just outlined for the market to fully perform its function of price discovery and allocating resources efficiently. The Bank will continue to conduct monetary policy appropriately and to contribute to achieving sustainable economic growth under price stability.
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Opening remarks by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the International Symposium "Ten Years After the Asian Currency Crisis: Future Challenges for the Asian Economies and Financial Markets", Tokyo, 22 January 2007.
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Toshihiko Fukui: Economic dynamism in Asia and regional cooperation Opening remarks by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the International Symposium “Ten Years After the Asian Currency Crisis: Future Challenges for the Asian Economies and Financial Markets”, hosted by the Center for Monetary Cooperation in Asia (CeMCoA), Bank of Japan, Tokyo, 22 January 2007. * 1. * * Introduction Good morning, ladies and gentlemen. Welcome to the first international symposium hosted by the Center for Monetary Cooperation in Asia, or CeMCoA for short. CeMCoA was established within the International Department of the Bank of Japan about a year ago with a view to promoting international cooperation among Asian central banks. Today, I am very pleased to welcome my close friends from the Asian central banking circle and the International Monetary Fund. Governor Zeti from Malaysia, Governor Tarisa from Thailand, Governor Abdullah from Indonesia, Governor Tetangco from the Philippines, and Managing Director Rodrigo de Rato of the IMF, I would like to thank all of them for joining us as guest speakers. I would also like to extend my heartfelt gratitude to all the distinguished audience gathering here. This morning, we would like to discuss the dynamism of Asian economies and the regional cooperation among central banks as well as the IMF. Looking at the Asian economies, China and India often attract attention, but at the same time no one can afford to overlook the importance of ASEAN countries. Japanese industries and financial institutions have a long history of close relationship with these economies, and will continue to do so for mutual benefits. Interdependence in Asia has come a long way despite the Asian currency crisis a decade ago. As demonstrated by the significant recovery and expansion in the last decade, the Asian economies are expected to make great leaps forward in the next decade. Today's guest speakers are the ones who will support these leaps. I believe this is a very good opportunity to discuss a forward-looking view of the Asian countries. 2. Economic dynamism in Asia As you may recall, the Asian currency crisis, which started with the sharp decline of the Thai baht in July 1997, spread to neighboring countries in a short period of time. Some ASEAN economies at that time suffered disruptions in their foreign exchange and financial markets, the massive outflow of capital resulted in the drying up of foreign reserves, the deterioration of banking systems and negative economic growth. Ten years later, everything is different: the foreign exchange and financial markets are much more stable and the currencies sometimes face upward rather than downward pressure; foreign direct investment and other capital inflow continues to grow with the accumulation of foreign reserves; the banking system has been strengthened through restructuring; and the economies have grown at a steady and sustainable pace of 5% on average since 2000. While there were indescribable difficulties to overcome the adverse effects of the crisis, the present performance clearly demonstrates the success of policy efforts and the underlying dynamism of the economies. I hope the speeches by the Governors will enlighten us about the changes in economies and dynamism after the crisis. 3. Regional cooperation Turning to policy coordination, the crisis became the starting point for various initiatives in the region. Exposed to the weakness in the international financial architecture, the ministries of finance and central banks became aware of the importance of regional cooperation and began to address the source of weakness. The Chiang Mai Initiative, as a complement to the IMF facilities, was agreed upon among ASEAN + 3 to build a framework of emergency liquidity support through a network of bilateral foreign exchange swap arrangements. Based on the analysis of the crisis, efforts have been made to reduce over-reliance on the banking sector for financial intermediation. The Asian Bond Markets Initiatives (ABMI) is another regional cooperation by ASEAN + 3 to foster local capital markets. Sharing the same objective with the ABMI, the Executives' Meetings of East Asia and Pacific Central Banks, or EMEAP, consisting of eleven central banks and monetary authorities in the region, started the Asian Bond Fund project. By utilizing some foreign reserves of member central banks collectively, the EMEAP launched two investment funds; one for investing in US dollar-denominated public bonds issued by the member countries, and the other for investing in local currency-denominated public bonds, to help not only to provide a convenient and low-cost instrument for market participants but also to identify and remove impediments to the respective local markets. 4. Future challenges for the Asian economies and financial markets In line with the good performance of regional economies and the progress in policy coordination among central banks and monetary authorities, economic integration in the region is gradually taking root. It is reported that intra-regional trade in East Asia has recently reached around half of the total, which is comparable to that of NAFTA and slightly less than that of the EU. Bilateral and regional free trade agreements are spreading throughout Asia. In addition, ASEAN is accelerating the process for building the ASEAN Economic Community (AEC) by 2015. It will be interesting to see how the present banking and other financial services change when a single market for goods and services is formulated in ASEAN. I hope the Governors can provide us with insights into developments of the AEC. With the globalization of the world's financial markets, large capital flows will continue to have a strong impact on open economies. This holds true for most of the Asian economies including the ASEAN. It is, and will surely be, the most difficult task for any monetary authorities to maintain the stability of foreign exchange rates, the free flow of capital, and the independence of monetary policy simultaneously. The answer to this proposition probably lies in the resilience of markets. In order to increase the ability to absorb external shocks from massive capital flows, the priority seems to strengthen the function of foreign exchange and financial markets in the region as a whole. In this regard, frequent exchange of information, deep analysis and concerted efforts by the EMEAP central banks will contribute to addressing risks and vulnerabilities in the markets. Such collaborative actions may cover the roles of the IMF, which commits itself to extensive reform to meet new challenges under the leadership of Rodrigo. Conclusion It is often said that Asia is highly diverse in culture, social framework and the stage of economic development. Since the Asian economies are in many respects very different from the European, we will probably follow our own process for economic integration. In that process, the better functioning of markets through regional cooperation will help provide a better business environment for industries and financial institutions, and lead to more efficient resource allocation. The more-than-ten-year history of EMEAP itself proves that cooperation based on mutual understanding and respect is possible in any circumstances. I am sure the guest speakers have various opinions on today's topics, and we will be able to appreciate their visions through our stimulating discussions. I would be delighted if this symposium helps you build insights into the dynamism of Asian economies and central bank cooperation in the region for the decade to come. Thank you.
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Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, to the Naigai Josei Chousa Kai (Research Institute of Japan), Tokyo, 10 May 2007.
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Toshihiko Fukui: The outlook for Japan's economy and the conduct of monetary policy Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, to the Naigai Josei Chousa Kai (Research Institute of Japan), Tokyo, 10 May 2007. * * * Introduction In the year since I last spoke to you here, Japan's economy has continued to expand moderately. Semiannually in April and October, the Bank of Japan explains its projection for the nation's economy in its Outlook for Economic Activity and Prices, or the Outlook Report for short. In the latest Outlook Report, which was released at the end of April, the Bank projected that from fiscal 2007 through fiscal 2008, the economy is likely to continue its sustained expansion, growing at a rate slightly above its potential. Today, I will focus on the Bank's view concerning developments in economic activity and prices based on the projection in the Outlook Report, and I will also explain the basic thinking regarding future monetary policy conduct. I. Developments in overseas economies I would first like to touch upon developments in overseas economies, which form the basis for the Bank's outlook for Japan's economy. Overseas economies taken as a whole continue to expand, with momentum being gained across a wide range of economies, and are likely to keep expanding. In the United States, although the pace of economic growth has recently been decelerating due mainly to ongoing adjustments in the housing market, the economy is likely to realize a soft landing and move onto a growth path at a rate near its potential as adjustments, particularly in household spending, become less severe. In the euro area, economic recovery has been solid, as the increase in production and improvement in corporate profits have led to recovery in business fixed investment and private consumption. Looking at East Asia, the Chinese economy continues to expand strongly with both exports and business fixed investment showing high growth, and the NIEs and ASEAN economies continue to expand at a moderate pace on the whole as domestic demand remains firm, despite a lull in exports. It was also the consensus view among delegates at the G-7 meeting in April that the global economy continues to expand robustly and is becoming more balanced. II. Current situation of Japan's economy Against the background of the generally favorable developments in overseas economies, Japan's economy has continued to expand moderately. Although exports to the United States are somewhat weak, overall exports continue to increase steadily reflecting the expansion of overseas economies. Business fixed investment continues to increase as corporate profits remain high. Production decreased in the January-March quarter of 2007 in reaction to the high growth in the previous quarter led by production in automobile-related goods, but it seems to be on a trend of 1 percent quarter-onquarter growth. As for the household sector, although growth of wages per worker has been somewhat sluggish due mainly to weak regular payments, employee income has continued to rise moderately supported by the increase in the number of employees. Property income such as dividends is also increasing. In this situation, growth in private consumption has recently resumed its upward movement, after sluggish growth over the summer of 2006 due to unfavorable weather conditions and consumers' reluctance to buy before the introduction of new products. In sum, although the pace of improvement in the household sector has been somewhat slow relative to the strength in the corporate sector, Japan's economy as a whole is expanding moderately. On the price front, domestic corporate goods prices have recently been about the same as their levels of three months earlier. The year-on-year rate of change in the consumer price index (CPI) excluding fresh food has recently been around 0 percent due to the drop in crude oil prices. III. Characteristics of the current economic expansion Let me now review the characteristics of the current economic expansion, in order to project the future course of the economy. The economic recovery began in January 2002, and its most distinctive feature is that the economy has been growing amid rapid globalization. Japanese firms – which have regained competitiveness as adjustment of excesses in production capacity, employment, and debt proceeds – have been increasing exports, against the background of global economic expansion and growing prevalence of international division of the production process. They have increased exports of a wide variety of goods – including capital goods and parts, automobiles, IT-related goods, and consumer goods – to an increasing number of countries. This strong performance of Japanese firms in the global market has led them to expect higher demand growth, thus accelerating business fixed investment. Economic growth achieved in this way has affected the distribution of the profits of economic growth to households. Faced with intensifying global competition and greater exposure to the discipline of the capital market, firms have changed the way they distribute profits. In an ever-changing competitive environment, they have been constraining increases in fixed costs and thus have continued to be cautious about increasing wages, particularly regular payments. Meanwhile, employees, having experienced a severe employment situation and currently facing intensifying global competition, have tended to prefer stable employment to a wage increase. Wage growth has therefore remained moderate despite the continuing high corporate profits. Nonmanufacturing firms, which have relatively little access to the global market, are also experiencing a severe market environment. In the nonmanufacturing sector, not only has deregulation led to increased supply with new entrants into the market, but also the decline in public expenditure has reduced demand. Given that changes in wages have become more closely linked to the level of corporate performance, the pace of increase in wages has been slower among nonmanufacturing than among manufacturing firms, reflecting their lower profits. In order to maintain competitiveness in the severe market environment, firms have continued to restrain labor costs. As a result, the pace of recovery in the household sector seems to be slower than people's expectations, despite the strength in the corporate sector. These features of the current economic expansion may also be affecting the environment surrounding prices. As firms have been restraining wages and also increasing productivity, upward pressure on prices seems to have been contained. Also, given that the driving force of current economic growth has been the corporate sector, especially globally active firms, and that the positive influence of the strength in the corporate sector has been relatively slow in feeding through into the household sector, supply and demand conditions for consumer goods and services are likely to improve more slowly than overall supply and demand conditions. In other words, while, from the demand side, growth in consumer demand is likely to be moderate given the slow pace of the flow of income from the corporate sector to the household sector, supply is likely to increase given the rise in imports due to economic globalization coupled with new entrants coming into the market as a result of deregulation. Looking at firms' perception of resource utilization, an indicator for supply and demand conditions, the weighted average of the diffusion indices of production capacity and employment conditions in the Tankan (Short-Term Economic Survey of Enterprises in Japan) suggests that the pace of improvement in resource utilization in consumption-related industries, such as retailing and services, is slower than the average for all industries. In recent years, the sensitivity of consumer prices to a rise in the utilization of resources such as production capacity and labor, or to changes in the output gap, has been declining, and this seems to have been due not only to deregulation and technological innovation but also to economic globalization. Another characteristic of the current economic expansion is that the financial environment has continued to be extremely accommodative, and this has been supporting private demand. This accommodative financial environment, together with the expansion of the global market and the progress in adjustment of excess production capacity mentioned earlier, has also underpinned the increase in business fixed investment. Interest rates have been very low relative to economic activity and price conditions. For instance, comparison of the real GDP growth rate with the real short-term interest rate – although the latter varies depending on how the expected inflation rate is estimated – shows that while the GDP growth rate has been around 2 percent, the real short-term interest rate has been in the range of around 0-0.5 percent if the actual year-on-year change in the CPI is used as the expected inflation rate. The lending attitudes of financial institutions have been positive reflecting expansion of risk-taking capacity as a result of improvement in their financial condition, and in this situation, the amount outstanding of lending by private banks has been increasing. In sum, the financial environment continues to be accommodative, both in terms of interest rates and availability of funds. The yen in terms of the real effective exchange rate has been moving at around its lowest level since the 1985 Plaza Accord, and this has been supporting growth in Japan's exports. Increases in asset prices, such as a more widely observed upturn in land prices, particularly in major cities, also seem to be exerting upward pressure on private demand. IV. Outlook for Japan's economy Next, I would like to elaborate on the outlook for Japan's economy based on the assessment of the current economic situation that I have described. From fiscal 2007 through fiscal 2008, Japan's economy is likely to continue its sustained growth of around 2 percent, somewhat above its potential. Given that the expansion of the global market and the accommodative financial environment – the two distinctive features of the current economic expansion – are likely to continue, the virtuous circle of production, income, and spending is expected to remain intact. In the corporate sector, business fixed investment is expected to keep increasing as exports continue to rise and corporate profits remain high. According to the March Tankan, firms' business fixed investment plans for fiscal 2007 are strong for initial estimates. As for the household sector, household spending is expected to follow a moderate upward trend as the positive influence of the strength in the corporate sector feeds through into the household sector slowly but steadily. Although firms are likely to continue to restrain labor costs, upward pressure on wages is likely to increase gradually as firms feel a growing shortage of labor. In fact, wages for temporary and part-time workers are rising, and an increasing number of firms are planning, for the first time in many years, to raise their starting salaries for new graduates. In this spring's wage negotiations, labor unions demanded slightly larger wage increases than hitherto and firms' management tended to accommodate them, at least to a certain extent. Firms may become more eager to hire or retain skilled workers in order to maintain and enhance their quality control expertise and their ability to provide value-added goods and services, both of which will give them a competitive edge in the long term. Acceleration in wage growth, coupled with the ongoing rise in the number of employees, will likely lead to a more firmly established uptrend in employee income. Property income of households is also expected to continue to increase due mainly to the rise in dividends, since households have been increasing their investments in financial instruments such as stock investment trusts. Furthermore, how baby boomers, who have started to retire, will spend their retirement benefits and savings should be watched closely. Thus, private consumption is likely to follow a moderate upward trend as the positive influence of the strength in the corporate sector feeds through into the household sector via various channels. In this situation, the environment surrounding prices is expected to gradually improve. If the economy continues to grow at a rate exceeding its potential for the next two years, the rate of utilization of resources such as production capacity and labor will further increase. In other words, the output gap will continue to indicate tighter supply and demand conditions. As the strength in the corporate sector leads to further increases in employee income, it is natural to expect that supply and demand conditions for consumer goods and services will improve and that this will exert upward pressure on consumer prices. Moreover, unit labor costs (labor costs per unit of output), although currently still declining with the growth rate of wages hovering around 0 percent, are likely to stop falling and start showing modest increases reflecting gradual rises in wages. Although inflation expectations in the private sector have shifted down due mainly to past falls in the prices of petroleum products, prices in general are still expected to increase moderately. Taking these developments into account, the year-on-year rate of change in the CPI is likely to be around 0 percent in the short run depending on developments in crude oil prices, but is expected gradually to rise in the longer run. However, the pace of increase is likely to be moderate, given that the sensitivity of prices to changes in the output gap is declining due to factors such as economic globalization and deregulation. The year-on-year rate of increase in the CPI is expected to be slightly above 0 percent in fiscal 2007 and around 0.5 percent in fiscal 2008. V. Upside and downside risks to the outlook for economic activity I have so far outlined the most likely projection for the next two years or so. However, the economy constantly faces various risks, and due attention should be paid to the possibility that economic activity and prices might deviate from this projection should particular risks materialize. In the April 2007 Outlook Report, we pointed out the following as upside and downside risks to the outlook for economic activity: developments in the global economy; supply and demand conditions for IT-related goods; and possible larger swings in financial and economic activity. Let me elaborate on each risk. The first risk concerns developments in the global economy, which is expected to keep expanding with momentum being gained across a wide range of economies. In the United States, adjustments in the housing market, including problems in the market for subprime mortgage debt, are still ongoing, and some leading indicators of business fixed investment have been showing somewhat weak developments. If adjustments in the housing market turn out to be greater than expected or business fixed investment weakens, economic growth may decelerate further. On the other hand, there is a risk that inflationary pressures in the United States may persist longer than expected, given that the rate of change in the core CPI has been somewhat elevated reflecting higher utilization of resources. If inflationary pressures do not subside, there is a risk that not only the U.S. but also the global economy and financial markets may be adversely affected, for instance, through the reaction of long-term interest rates and foreign exchange rates to this situation. In China, there is an upside risk of the economy growing faster than expected, particularly fixed asset investments and exports. Whether this risk can be reduced and the Chinese economy can realize stable growth even after the 2008 Olympic Games in Beijing should be the focus of attention. The second risk concerns supply and demand conditions for IT-related goods. Inventory adjustments of IT-related goods are continuing, and this seems to be the result mainly of specific domestic factors, namely, the slow improvement in the balance of inventories and shipments for electronic parts, particularly those related to cellular phones. Global demand for IT-related goods has so far been on an upward trend due partly to the rapid growth in emerging-market economies, such as the BRICs, and thus inventory adjustments should basically come to an end in or after the middle of 2007. However, if expected global demand is revised significantly downward in response to, for instance, a deceleration in the global economy, there is a possibility that adjustment pressures on inventories may intensify, since the pace of increase in global supply tends to be rapid in the IT-related sector. The third risk concerns possible larger swings in financial and economic activity based on optimistic assumptions regarding, for example, financial conditions. Japan's current economic circumstances, with the financial positions of both firms and financial institutions improving and real interest rates remaining very low, are such as potentially to encourage assertive financial and economic activity. As for foreign exchange rates, the real effective exchange rate is at the lowest level since the 1985 Plaza Accord, and the upward trend in land prices in major cities has become increasingly distinct as seen in the fact that commercial land prices in Tokyo and Osaka in March's Land Price Publication showed a double-digit increase from the previous year. These developments in foreign exchange rates and asset prices may also cause activity of both firms and financial institutions to accelerate. Should greater assertiveness be based on optimistic assumptions regarding future profitability, such as too rosy expectations for the growth rate, financing costs, foreign exchange rates, and asset prices, the result could well be a misallocation of resources in the long run as agents become over-extended in financial markets or pour funds and other resources into inefficient economic activities. Such behavior may push up economic growth and asset prices in the short run, but it can lead to later downward adjustments and hamper the sustainability of economic growth. VI. Upside and downside risks to the outlook for prices These upside and downside risks to the outlook for economic activity may affect prices if they should materialize, but there are also upside and downside risks unique to price developments that could cause prices to deviate from the projection. In the April Outlook Report, two risks are noted: uncertainty concerning the sensitivity of prices to changes in the output gap, and developments in the prices of crude oil and other commodities. The sensitivity of prices to changes in the output gap has been declining in recent years due partly to economic globalization. This tendency has been taken into account in the projection for prices mentioned earlier, but the sensitivity of prices may turn out to be lower than assumed in the projection. If, despite prolonged economic expansion, wage growth were to remain low relative to the pace of productivity gains, downward pressure on prices from labor costs would persist. Moreover, if the positive influence of the strength in the corporate sector feeds through into the household sector slower than expected due to sluggish wage growth, supply and demand conditions for consumer goods and services may not improve in line with the diminishing slack in the economy. In such a situation, prices may not be responsive to the improvement in the economic situation. On the other hand, if the economy continues to grow at a pace exceeding the potential through fiscal 2008, it is likely that the rate of utilization of resources such as production capacity and labor will rise further and the output gap will show further tightening of supply and demand conditions. Inflation expectation, which has been low and stable, may increase with higher resource utilization, particularly in labor. Moreover, although firms are likely to continue to restrain labor costs, they may change their attitude with the aim of hiring or retaining skilled workers. These potential changes would exert upward pressure on prices. Prices of crude oil and other international commodities may deviate either upward or downward from the projection depending on factors such as geopolitical risks. Close attention should be paid to developments in these prices, since they will have a substantial effect on domestic corporate goods prices and consumer prices. VII. Conduct of monetary policy Let me now explain how the Bank will conduct monetary policy based on the outlook for the economy and prices I have outlined, giving due regard to the possibility of upward or downward deviation. In March 2006, when the quantitative easing policy was terminated, the Bank introduced the "New Framework for the Conduct of Monetary Policy." It consists of three elements. The first is releasing the "understanding of medium- to long-term price stability," the second, assessment of the economic and price situation from two perspectives taking account of the "understanding of medium- to long-term price stability," and the third, outlining the Bank's thinking on the future course of monetary policy. The "understanding of medium- to long-term price stability" is the level of inflation that each member of the Policy Board understands, when conducting monetary policy, as being consistent with price stability over the medium to long term. Each member, with this understanding in mind, judges whether Japan's economy will achieve sustainable growth under price stability, and makes policy decisions based on this judgment. At the Monetary Policy Meeting at the end of last month, we conducted a review of the "understanding," in accordance with the decision that it should be reviewed, in principle, annually. First, the basic understanding concerning price stability was reviewed, and it was reaffirmed as follows. Price stability is a state where various economic agents including households and firms may make decisions regarding economic activities without being concerned about fluctuation in the general price level. Given that the effects of monetary policy take time to work through the economy and that the volatility of output may actually be amplified when attempts are made to absorb every shortterm change in prices resulting from various shocks, the Bank should forecast developments in economic activity and prices from a sufficiently long-term viewpoint and strive to realize price stability over the medium to long term. Furthermore, in examining the "understanding of medium- to long-term price stability," the following points were considered. First, the significance of measurement bias in the CPI. Second, the necessary extent of the "safety margin" that acts as a buffer against the risk of falling into a vicious circle of declining prices and deteriorating economic activity. And third, possible changes in the level of inflation perceived by households and firms as consistent with price stability. As for the first point, it seemed that measurement bias remained insignificant even taking into account last year's rebasing of the CPI. Regarding the second point, the "safety margin," the risk of the economy falling into a deflationary spiral seems to have further decreased, since the strength of the corporate sector and robustness of the financial system have further improved. Finally, on the third point, the level of inflation perceived by households and firms as consistent with price stability is unlikely to have changed much, since changes in the inflation rate have been small. Based on these considerations, it was agreed, as was also the case a year ago, that the "understanding of medium- to long-term price stability" expressed in terms of the year-on-year change in the CPI, takes the form of a range approximately between 0 and 2 percent with most Policy Board members' median figures falling on one side or the other of 1 percent. The next step, the examination from two perspectives, involves assessment of the outlook for the economy and prices from two standpoints – whether the main scenario leads to the attainment of our objective and how other relevant risks should be evaluated. From the first perspective, we examine the prospects for economic activity and prices for one to two years ahead – this time, through fiscal 2008 – and assess whether the most likely outlook is for the economy to follow a path of sustained growth under price stability. Through fiscal 2008, the economy, as I said earlier, is likely to continue its sustained expansion with a virtuous circle of production, income, and spending in place. The year-on-year rate of change in the CPI (excluding fresh food) is likely to be around 0 percent in the short run, but is expected gradually to rise in the longer run. Such developments can be regarded as in line with the "understanding of medium- to long-term price stability" that each member of the Policy Board has in mind. In sum, we judged that, through fiscal 2008, Japan's economy is likely to realize sustainable growth under price stability. This outlook is based on the assumption that market participants and firms make decisions by factoring in future changes in monetary policy. Thus, adjusting the level of the policy interest rate will become necessary for the economy and prices to continue to follow the projection. The pace of necessary adjustment, however, will depend on the degree of future improvements in the economy and price situation. We do not, therefore, have any predetermined schedule. The second perspective extends the time horizon and assesses the risks considered most relevant to the conduct of monetary policy. In this assessment, we take account of the cost incurred should risks materialize, even though the probability of this happening may be low. In this regard, both upside and downside risks need to be borne in mind. In terms of the upside risks, we need to be mindful of the stimulative effect of monetary policy being further amplified with the improved prospects for economic activity and prices. If, for instance, the expectation takes hold that interest rates will remain low for a long time regardless of developments in economic activity and prices, then firms and financial institutions may over-extend themselves based on such expectation, resulting in medium- to long-term risks of larger swings in the economy and inflation rate, and of misallocation of funds and resources. On the other hand, if the downside risks mentioned earlier should materialize, the improvement in the economic situation may stall. It is also possible that prices will continue not to rise despite the improvement in economic conditions. Nevertheless, the risk of the economy falling into a vicious circle of declining prices and deteriorating economic activity seems to have further decreased, since the strength of the corporate sector and the robustness of the financial system have been enhanced. Based on this outlook and assessment of risks, we have decided to maintain the current basic thinking regarding the conduct of monetary policy, employed since the termination of the quantitative easing policy in March 2006. The Bank adjusted the level of the policy interest rate in July 2006 and in February 2007. Adjustments were made in view of the outlook for the economy and prices, with the Bank judging that sustained economic growth would continue with a virtuous circle of production, income, and spending in place, and that consumer prices would be likely to increase moderately in the long run in line with the "understanding of medium- to long-term price stability." Based on this assessment, we have been realizing the idea of "adjusting the level of interest rates gradually in the light of developments in economic activity and prices." With inflationary pressures weak, the pace of adjustment has been slow and the accommodative financial conditions ensuing from very low interest rates have been maintained. The Bank's basic thinking in this regard will remain the same in the conduct of future monetary policy. In sum, while confirming that Japan's economy remains likely to follow a path of sustainable growth under price stability in light of the aforementioned "understanding" and assessing relevant risk factors, the Bank will adjust the level of interest rates gradually in accordance with improvements in the economic and price situations. Concluding remarks Lastly, I would like to touch upon the Bank's communication of information concerning the conduct of monetary policy. The Bank will continue to explain carefully to the public its assessment of economic activity and prices and its basic thinking on the conduct of monetary policy in line with the "New Framework for the Conduct of Monetary Policy," through, for example, the Outlook Report. In relation to this point, there are voices that call for the Bank to communicate information on the specific time schedule of a policy change, but we neither believe it possible nor consider it appropriate to do so. The Bank considers that there are two key pieces of information that it should provide, namely, its assessment of economic activity and prices, and its basic thinking on the conduct of monetary policy. Taking into consideration such information provided by the Bank, market participants carry out transactions based on their views regarding economic activity and prices; the Bank in turn obtains information regarding market participants' views on economic activity and prices from interest rates formed in financial markets as a result of transactions carried out by market participants, and uses it in making its assessment of economic activity and prices. We think such a two-way communication process is important. If, however, the central bank were to indicate a specific time schedule for a policy change, market participants would carry out transactions based not on their own views regarding economic activity and prices but on the Bank's indication. Therefore, we think it is vital that the central bank's communication to the public should be limited to the extent I have just outlined for the market to fully perform its function of price discovery and allocating resources efficiently. The Bank will continue to conduct monetary policy appropriately and to contribute to achieving sustainable economic growth under price stability.
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Statement of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, concerning the Bank's Semiannual Report on Currency and Monetary Control before the Committee on Financial Affairs, House of Councillors, 10 May 2007.
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Toshihiko Fukui: Semiannual Report on Currency and Monetary Control (Bank of Japan’s overall review) Statement of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, concerning the Bank's Semiannual Report on Currency and Monetary Control before the Committee on Financial Affairs, House of Councillors, 10 May 2007. * * * Introduction The Bank of Japan submitted its Semiannual Report on Currency and Monetary Control for the first half of fiscal 2006 to the Diet on December 12, 2006. I am pleased to have this opportunity to present an overall review of the Bank's conduct of monetary policy. I. Developments in Japan's economy Japan's economy is expanding moderately. Exports have continued to increase due to the expansion of overseas economies. Business fixed investment has also continued to increase against the background of high corporate profits and generally favorable business sentiment. The positive influence of the strength in the corporate sector has been feeding through into the household sector. As firms have been increasingly feeling a shortage of labor, the number of employees has continued to increase steadily and household income has continued to rise moderately. In this situation, private consumption has been firm. With the rise in demand both at home and abroad, production has been on an increasing trend and inventories as a whole have been more or less in balance with shipments. Looking forward, Japan's economy is likely to experience a sustained period of expansion with a virtuous circle of production, income, and spending in operation. The Bank will, however, continue to pay close attention to developments in overseas economies, including the United States, as well as crude oil prices. On the price front, domestic corporate goods prices have recently been more or less at three-monthearlier levels. They are expected to increase in the immediate future mainly due to the rebound in international commodity prices. The year-on-year rate of change in the consumer price index (CPI; excluding fresh food) has been around zero percent due to the drop in crude oil prices, but from a longer-term perspective it is projected to continue to follow a positive trend as the output gap continues to be positive. As for financial conditions, the environment for corporate finance has been accommodative. In the corporate bond and CP markets, the issuing environment has been favorable. The lending attitudes of private banks have continued to be accommodative. Credit demand in the private sector has been rising. Under these circumstances, the amount outstanding of lending by private banks has been increasing. II. Conduct of monetary policy The Bank changed the guideline for money market operations at the Monetary Policy Meeting (MPM) in February, raising the uncollateralized overnight call rate target to around 0.5 percent. This policy adjustment was made in line with the framework for the conduct of monetary policy introduced in March 2006. The Bank reviewed the outlook for Japan's economy based on data and information on domestic and overseas economies available at the time of the MPM in February. Its assessment at that meeting was as follows: the CPI is likely to increase as a trend as the economy continues to expand moderately; and with the prospects of the economic and price situation improving, the stimulative effect of monetary policy, if the policy interest rate were kept unchanged, could gradually increase, and if the expectation takes hold, in such a situation, that interest rates will remain low for a long time regardless of developments in economic activity and prices, there is a medium- to long-term risk of larger swings and of inefficient allocation of resources as firms and financial institutions over-extend themselves. The Bank judged at the MPM in February that it was appropriate to adjust the level of the policy interest rate in order to maintain a desirable course of economic activity and prices. This policy action will still keep the monetary environment very accommodative, and the Bank believes that it will contribute to ensuring price stability and achieving sustainable growth in the medium to long term. The Bank presented its basic thinking on the future course of monetary policy in the April 2007 Outlook for Economic Activity and Prices, along with the outlook for economic activity and prices. In sum, while confirming that Japan's economy remains likely to follow a path of sustainable growth under price stability and assessing relevant risk factors, the Bank will adjust the level of interest rates gradually in accordance with improvements in the economic and price situation. The Bank is determined to conduct monetary policy appropriately in the light of developments in economic activity and prices, and contribute to sustainable economic growth under price stability.
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Opening speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the 14th International Conference hosted by the Institute for Monetary and Economic Studies, Bank of Japan, Tokyo, 30 May 2007.
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Toshihiko Fukui: Growth, integration and monetary policy in East Asia Opening speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the 14th International Conference hosted by the Institute for Monetary and Economic Studies, Bank of Japan, Tokyo, 30 May 2007. * I. * * Introduction Good morning, ladies and gentlemen. It is my great honor to address the 14th international conference hosted by the Institute for Monetary and Economic Studies. On behalf of my colleagues at the Bank of Japan, I welcome all the distinguished guests from central banks, international organizations, and academia. The theme of this year’s conference is “Growth, Integration and Monetary Policy in East Asia.” II. East Asia’s growing integration into the global economy Over the past decades, East Asia has been one of the most rapidly growing regions in the world economy. Although the region suffered from a temporary setback owing to the financial crisis of the late 1990s, it has exhibited an impressive economic recovery. The average annual growth rate of East Asian emerging economies since 2000 reached 7 percent, substantially exceeding that of industrialized economies. Since the crisis, there has been a considerable improvement in economic fundamentals in the region. Large stocks of foreign exchange reserves have accumulated, balance sheets of both the corporate and banking sectors have improved, and structural reforms in various areas have proceeded, all of which have contributed to making East Asia more resilient to external shocks. It is highly likely that East Asia will continue to play a major part in the sustained growth of the world economy. East Asia’s high growth has been accompanied by its deepening economic integration with the world. The integration is taking place at both the inter-regional and intra-regional levels. It is reported that Asia’s share of world trade more than doubled during the past three decades. Intra-regional trade in East Asia also increased considerably. The share of East Asia’s intra-regional trade is comparable with the NAFTA, although it is slightly lower than that of the EU. The increasing trade is a reflection of developments in the supply chain wherein each country specializes in the optimal parts of the global production network based on its resource endowment and comparative advantages. Meanwhile, it is notable that the rapid emergence of China is adding further momentum to the growth dynamism of the world economy in various ways. First, China’s buoyant domestic demand provides more business opportunities for the rest of the world. China’s role in the world economy has gone beyond a mere production base. It is increasingly a source of final demand as well. Second, China’s integration into the global economy is promoting transformation of trade, investment, and production patterns of other economies. Previously, China maintained its comparative advantages mainly in production of goods and services that were intensive in the use of unskilled labor. In recent years, however, it has attracted sizable foreign direct investment from developed countries and thereby strengthened its competitiveness in production of capital-intensive or knowledge-intensive goods and services. Such changes on the part of China have affected comparative advantages of other East Asian economies as well and required them to reallocate domestic resources accordingly. The efficient reallocation of resources could, in principle, lead to higher growth of the region as a whole. At the same time, however, the adjustment process sometimes entails certain costs. If domestic markets and institutions are not flexible enough to facilitate reallocation of labor and financial resources from unproductive sectors to productive sectors smoothly, the cost might appear in the form of stagnant growth and unemployment. In this regard, it is of utmost importance for policymakers to continuously pursue reforms to ensure that their domestic systems remain responsive to structural changes in the economy. On the financial front, East Asia’s integration with the international financial system has also advanced steadily in recent years. The integration brings benefits to the economies in the region. With more funding options available, borrowers in the region can raise funds on more favorable terms. With more global investment options available, investors can improve the risk profile of their portfolio through diversification. However, as financial integration deepens and international capital flows become more active, negative shocks originating from one country or region are easily transmitted to another country or region. Such transmission of shocks is not only from developed economies to emerging economies, but also vice versa. Asset prices, in particular, stock prices, are closely correlated both globally and regionally. It should be noted that, in such circumstances, asset prices tend to overshoot economic fundamentals from time to time, causing excessive volatility, which could in turn negatively affect the developments in the real economy. III. Issues for discussion at the conference Whereas East Asia’s integration could bring substantial benefits to both the global and regional economies, possible side effects should be monitored carefully. It will be a challenge to reap maximum benefits from deepening economic and financial integration while minimizing costs that could possibly arise from such integration. Keeping these broad viewpoints in mind, let me raise several questions that I hope are discussed at the conference. First, what are the implications of East Asia’s growing economic and financial integration on the global business cycle and price movements? The mechanisms through which integration affects various economic variables are complicated. Among these, the relationship between global economic integration and the inflation process is of particular interest to central bankers. Integration of emerging economies including East Asian economies appears to have exerted downward pressure on wages and prices through intensified competition among firms. Whether this trend will continue into the future will have important bearings on the conduct of monetary policy. Second, what issues are raised for central banks of industrialized economies and East Asian emerging economies by growing external imbalances? It has been argued that global economic and financial integration has contributed to making large current account imbalances more sustainable. East Asia has been a beneficiary of a substantial amount of private capital flows from developed economies, and at the same time, an exporter of an even greater amount of capital in the form of foreign reserves. This is not consistent with the prediction of traditional economic theory that capital flows from developed economies to emerging economies where the marginal productivity of capital is higher. A question naturally arises as to whether the phenomenon has been driven by the fundamental misallocation of global savings and investment. In any case, disorderly unwinding of the imbalances and accompanying capital flows would have detrimental impacts on global financial stability. It is critical for us to carefully examine the factors underlying the imbalances and the desirable policy for both surplus and deficit economies. Third, what kind of monetary and exchange rate regimes are appropriate for East Asian emerging economies to pursue sustained economic growth under price stability? In the world of highly open capital accounts, the effectiveness of monetary policy depends on the exchange rate regimes in place. After the crisis, there has been a tendency in emerging economies to abandon exchange rates as a nominal anchor. As a matter of fact, a growing number of economies have moved away from pegged exchange rate regimes toward relatively more flexible exchange rate regimes. So far, it seems that the benign international market environment for emerging economies in recent years has made such a transition more or less smooth. Nevertheless, the extent to which exchange rate fluctuation should be tolerated remains a challenging question. Looking ahead, the appropriate policy regimes could change over time. It is important for central banks to review the appropriateness of the policy regimes in light of the changes in their economic and financial structure and the state of the international financial system. IV. Conclusion To conclude, East Asia has been in the process of dynamic transformation. We are still a long way from fully understanding the policy implications of East Asia’s integration into the global economy. I am looking forward to learning from both prominent scholars and central bankers their analyses and perspectives on the issues. I would be delighted if all of you could take away some insights from the discussion. Thank you for your attention. Note: “East Asia” or “East Asian emerging economies” is defined as comprising of People’s Republic of China, Hong Kong, Korea, Singapore, Taiwan, Indonesia, Malaysia, the Philippines, and Thailand.
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Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the International Conference on Inflation Dynamics, hosted by Hitotsubashi University, Tokyo, 28 June 2007.
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Toshihiko Fukui: Inflation dynamics and monetary policy Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the International Conference on Inflation Dynamics, hosted by Hitotsubashi University, Tokyo, 28 June 2007. * * * It is my great pleasure to be invited to speak before such distinguished economists from both Japan and overseas. The theme of this conference, "Inflation Dynamics," is, without any question, one that cannot be ignored by any central banker pursuing the most desirable monetary policy. Presumably it is the interest in a central banker's perspective on this key topic that explains why I have been given the privilege of speaking to you today. Accordingly, I would like to take this opportunity to give my thoughts on the subject. The issue of inflation dynamics has been studied for a long time, yet remains as relevant today as ever. The year I joined the Bank of Japan, 1958, was the year when the seminal paper by Professor Alban W. Phillips was published. Half a century on, the basic idea behind the Phillips curve has been considerably extended, and many related theories have evolved in connection with the role of expectations, the mechanisms that bring about price rigidity, and so forth. For monetary policy to achieve its objective of price stability, it is extremely important to accurately understand the dynamics of inflation. These dynamics, however, may change along with changes in the economic structure, and it is often difficult to detect such changes in a timely manner. This often becomes a source of anxiety to central bankers conducting monetary policy in the real world. In recent years, especially, the biggest challenge facing central bankers may be the conduct of monetary policy in the face of the flattening of the Phillips curve and increase in uncertainty with regard to inflation dynamics. With a flatter Phillips curve and given a situation where the inflation rate is within the desirable range, small economic fluctuations will not cause the inflation rate to shift outside the range. On the other hand, a flatter Phillips curve means that, once inflation shifts outside the range, bringing it back is that much harder, since the output gap or the change in the output gap necessary to raise or lower the inflation rate becomes correspondingly larger. For example, in the United States, Governor Mishkin of the Federal Reserve Board, in his speech delivered in April, stated that "returning inflation too quickly to levels consistent with price stability might unnecessarily exacerbate the economic weakness. Instead, while restoring price stability remains critical, the central bank should do so at a pace that does not do undue harm to the economy." In Japan, we are experiencing a similar problem, although the direction is quite the opposite. Japan's economy has been growing at a rate above its potential for some time. Utilization of resources such as production capacity and labor has been increasing, and the estimates of the output gap are suggesting tighter supply and demand conditions. On the other hand, the response of prices to this situation has been very weak, leaving the current inflation rate near 0 percent. In a situation like this, the extent of the output gap needed to raise the inflation rate in a short period of time becomes not only very large but also subject to significant uncertainty. An abrupt widening of the output gap may bring about larger swings in the economy and risk the sustainability of the economic expansion. The alternative, safer route is to focus on securing sustained economic growth and minimizing swings, generating corresponding expectations of a moderate and gradual rise in the inflation rate. As you might expect, it is this latter approach that is behind the Bank of Japan's current gradual adjustments in the level of interest rates. Historically, inflation dynamics have often exerted considerable influence on central banks' policy frameworks and their conduct of monetary policy. Experience of high inflation up to the 1980s, for example, encouraged the development of monetary policy frameworks focusing on prices, such as "inflation targeting" regimes. Since then, prices have tended to stabilize and the Phillips curve has become flatter. Such changes in inflation dynamics have made it necessary for central banks to look at the broader picture in their pursuit of price stability. To be more specific, with a flatter Phillips curve, imbalances in the economy do not easily translate into movement in prices. On the contrary, it is possible that imbalances may make themselves felt on the real side of the economy or in asset prices before they are translated into instability in general prices. This has indeed induced central banks, including those that have adopted inflation targeting, to gradually shift their attention to achieving price stability in the longer run through flexibly responding to economic developments as well as prices. The framework for the conduct of monetary policy that the Bank of Japan adopted when it terminated the quantitative easing policy in March 2006 was constructed with these inflation dynamics in mind, and in full awareness that they may evolve further in the future. As I just mentioned, inflation dynamics may change in the future, and such uncertainty is another crucial point that should be taken into consideration in the conduct of monetary policy. Specifically, no one knows whether the flattened Phillips curve will be a lasting phenomenon. In our Outlook Report published in April, we pointed out that the shape of the Phillips curve may change along with changes in inflation expectations or labor cost restraint by firms. Moreover, there is more than one hypothesis competing to explain the flattening of the Phillips curve: for example, some point to decrease in firms' control over prices as a result of the stiff competition following deregulation and globalization, while others refer to the decreasing frequency of price revisions by firms in response to disinflation. Inevitably, the outlook for the future differs depending on the hypothesis favored. Actual economic developments always entail uncertainty, and not only for the reasons I just stated. Just as with other economic challenges, a final resolution to the problems posed by inflation dynamics may be too much to ask for. Yet in spite of this, central bankers must keep up with the cutting-edge ideas and insights of their time and reflect them in their policy management. As one such central banker, I am very much looking forward to seeing our understanding of inflation dynamics deepened thanks to the research efforts stimulated by conferences such as this. Thank you very much for your attention.
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Summary of a speech by Mr Kazumasa Iwata, Deputy Governor of the Bank of Japan, at the Panel Session "Housing and Monetary Policy" at the Federal Reserve Bank of Kansas City's Economic Symposium, Jackson Hole, Wyoming, 1 September 2007.
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Kazumasa Iwata: Housing and monetary policy in Japan Summary of a speech by Mr Kazumasa Iwata, Deputy Governor of the Bank of Japan, at the Panel Session "Housing and Monetary Policy" at the Federal Reserve Bank of Kansas City's Economic Symposium, Jackson Hole, Wyoming, 1 September 2007. * * * Housing and measurement of inflation rate 1. There are four approaches to the treatment of housing, including owner-occupied housing, in the Consumer Price Index, depending on whether the goods or services are "used", "consumed", "paid" or "acquired", namely (1) user cost, (2) rental equivalent, (3) payments, and (4) net acquisition methods. The first two methods seem appropriate for the measuring of the "cost of living", as they cover the consumption of the service produced by housing. The payments method reflects the actual outlay for owning a dwelling for shelter purposes; it can be regarded as a simplified version of the user cost method. The user cost method, as adopted by Canada and Sweden, includes the opportunity cost of owning a dwelling (the interest rate) and expected changes in house prices, in addition to relative price of houses, depreciation, tax, repairs and maintenance. 1 There is an issue as to whether we should include the price of the land in the calculation of user cost, an issue which has important policy implications for the transmission mechanism of monetary policy in the case of Japan. On the other hand, if we want "household monetary expenditure" to be reflected in the CPI, then the net acquisition method (in the sense of excluding the transaction of existing dwellings) may be preferred, since this treats the purchase of housing the same as for durable consumer goods. This method also may involve including the asset component in the CPI, of particular relevance if the land is included (Eiglsperger (2006)). 2. In Japan we adopt the rental equivalent method in the measurement of inflation rate, as is the case in the U.S. and five of the EU countries. The rental equivalent method estimates the costs for owner-occupied housing services with reference to rental payments for similar rental houses. There remains an issue as to whether the paid rent is considered fully representative of the imputed rent, because of the difference in quality and floor-size distribution. 2 Equivalent rent has continued to decline in recent months, despite the recovery in land prices. The movement in housing rent seems to be associated more with sticky wages than with flexible land prices (Figure 1). This may reflect a stable share of shelter costs in the household budget. Due to the large share of housing services in the consumer price index (17%) as well as the weak development in wages since the end of 2006 (Figure 2), service The user cost of housing can be derived from the intertemporal maximization of utility function by households, whereby, the utility function comprises various goods and services, including housing services. However, it is somewhat uncomfortable for central bankers to include the real market interest rate in the measurement of inflation rate, as is the case of mortgage interest payment in the payments method. Further, the possibility of reselling houses makes the calculation of the user costs of housing capital more complicated, because it involves the issue of the optimal choice of timing of reselling under the diversified tax system on capital gains. In addition, due to regulations and the different tax treatments for rental and owner-occupied houses, there is a selection bias in measuring the implicit rent of owner-occupied house. prices have moved around zero, in sharp contrast with other developed economies where they hover around 3-4%. 3 Asset price aspect: future price index or wealth price index 3. Housing has two aspects for consumers; it renders housing services like other durable goods, and at the same time, houses for rent or owner-occupied houses are held as assets. These two aspects provide us with an interesting insight into current and future price indexes. 4. Housing as an asset produces housing service for the future. Moreover, the fundamental price of housing is equal to the present value of future housing service stream. If we attach importance to the asset aspect of housing, it seems natural to ask whether we can extract a signal or guide to future price developments from the movement of asset prices. Alchian and Klein (1973) proposed the construction of an "intertemporal cost of living index", under the constant utility level, based on individuals' intertemporal optimization behavior, by using the data on all tangible and non-tangible assets in the economy. This idea of an intertemporal cost of living index, or "wealth price index", can be traced back to I. Fisher (1906). 5. Shibuya (1992) attempted to calculate just such a wealth price index. He named it the "dynamic equilibrium price index", based on the assumption that the economy moves along a balanced growth path (the "modified golden rule path"). After constructing the wealth price index as the weighted geometric mean of current product price inflation (GDP deflator) and future price changes represented by aggregate asset price of the national wealth in the national accounts, he argued that the BOJ could have envisaged future inflation if the wealth price index had been employed in the mid-1980s, in addition to the conventional CPI (Figure 3). Shiratsuka (1999) carried out the Granger causality test and confirmed the result of the potential usefulness of the aggregate asset price index as an information variable, although he also reported that its usefulness depends on the sources of asset price changes and the macroeconomic environment. 6. There are, however, a number of shortcomings with the dynamic equilibrium price index if we want to employ it as one of the important information variables in conducting monetary policy. First, human wealth is omitted in the calculation of total assets, despite the fact that, in Japan, the total value of human capital is about three times larger than that of non-human capital (Iwata (1992)). Second, there is the problem of sizable observation errors with the aggregate asset price, as compared with the CPI or the GDP deflator, in addition to the two-year delay in the availability of data. The weak development of wages in recent months can be attributed to the retirement of the first baby boomers, who number about 8 million and who are being replaced by young workers or reemployed as parttime workers, public sector wage cuts introduced to consolidate the budget balance, and the restructuring at smaller non-manufacturing firms with low productivity. The final factor is related to the distortion of relative wages, which Hayek (1975) described as "one of the basic elementary connections between wages and investment wholly overlooked in Keynesian economics". Third, the wealth price index is constructed based on two assumptions, namely, that the asset price is equal to the fundamental price on a balanced growth path, and that the marginal productivity of aggregate asset remains constant, disregarding the composition change in the national wealth. If these two assumptions are untenable, then the index derived may fail to provide useful information on future price developments. We cannot escape from the identification problem associated with asset price bubbles. If we look at the calculated DEPI, we find that it is strongly influenced by movements in the price of land, because of the large weight of land value in the national wealth; it is about half of national wealth, and the proportion of land value for residential use is about four times larger than the value of dwellings in 2005. Despite these shortcomings, it may be useful to carry out a model simulation of the balanced path to show the deviation of the observed DEPI from the model simulation outcome. Furthermore, it seems to be important to observe directly the price of land, and examine the factors and sources of price movements, to draw useful information for monetary policy implementation. Land as collateral 7. One of the important differences between housing and other durable goods is that the use of land is essential for producing housing services. In the case of Japan, the value of land accounts for a larger share in residential property and the national wealth than in other advanced economies. Land has been employed as the most important collateral for bank lending. It also constitutes one of the most popular properties for inheritance, due to the lower effective tax rate applied to land holdings than to other assets. 8. Some economists have argued that the Japanese bank-dominated financial system was based on the "land standard" during the "high growth era", because of the importance of land as collateral. The price of land in Japan had increased persistently in the period from the 1950s to the bursting of the land-price bubble in the early 1990s, with a short interruption in the mid-1970s (Figure 4). The price of land has often deviated from the fundamental price, due to the lack of information, high transaction costs and the mistaken perception of land as an asset of ever-increasing value. The total land value became five times larger than nominal GDP at the peak of the bubble period (Figure 5), despite the fact that the historical average of the ratio is about 2. In addition, the insight derived from the neoclassical growth model, including land as a production factor, indicates a much lower ratio (Iwata and Hattori (2003)). 4 Asset price bubble and option theory 9. An asset price bubble will emerge through the financial accelerator mechanism based on various frictions and the incompleteness on the financial market, combined with the excessive provision of liquidity and the euphoria brought about by expectations of higher The steady state ratio of total land value to nominal GDP can be expressed as the product of the time preference rate, the expected population growth rate and the share of land rent in national income. Given the values of 3% for the time preference, 1% growth rate for population and 5% land rent share, the steady state ratio is 2.5. Aging and a declining population suggest a much lower ratio, as compared with the high growth era (Iwata and Hattori (2003)). growth. In addition, the mispricing of option values attached to land and mortgage loans may lead to an asset price bubble and aggravate the effect of an asset price bubble burst. 10. Land itself can be put to many different uses, such as residential, non-residential and commercial use. Lax zoning regulation creates the possibility of land being converted to more intensive and profitable use. In this case, the price of land consists of the fundamental price and the option value of conversion to more profitable use. The option value resembles a convertible bond (Kanoh and Murase (1999)). If the option premium is overpriced under the perception of ever-rising land value, the option value for convertible use of land may give rise to accelerated land prices; it has in fact been observed that residential land prices follow the acceleration of commercial use land prices. The price of commercial land in Japan's major cities has risen more than 10% recently. 11. From the perspective of option theory, housing loans are more complicated financial instruments than at first might appear. They incorporate call options in the case of prepayment (to buy the asset), as well as put options in the case of bankruptcy (to sell the asset). 5 Profs. Pavlov and Wachter (2006) have pointed out the possibility of the underpricing of default risk in all non-recourse asset-backed mortgage loans, due to inappropriate deposit insurance schemes and the asymmetry of information. The underpricing of default risk or distorted put option values may lead to inflated asset prices and cause far deeper asset market crashes. Moreover, default risk is easily underestimated against a backdrop of rising house prices. In addition, there is a risk that in the process of securitizing mortgage loans such as CDOs, the default risk can be further underpriced by rating agencies in the assessment of correlation of default risks among the bundle of different mortgage loans. The use of mark-tomodel instead of mark-to-market in complex structured products may also lead to the widescale underpricing. Inflation and asset price bubble 12. On the relationship between the inflation rate and asset prices, the above-trend rise in land value relative to nominal GDP indicated clearly the emergence of a bubble after 1987. The weak corporate governance of borrowing firms, coupled with a weakening of the monitoring function of main banks which were relying on land as collateral, gave rise to a positive association of asset price rise with higher leverage ratio. Yet at that time, core CPI (excluding fresh food) was close to zero. This is partly due to the sharp appreciation of the yen rate after the Plaza Accord in 1985, coupled with the oil price decline (figure 6). Further, the October crash in 1987 reinforced the need for international cooperation on the provision of liquidity for Japan as the largest creditor country. 13. On the excessive provision of liquidity, we can say that the sustained deviation of actual real money stock from the equilibrium real money stock (real money gap) after the mid1980s, created the circumstances where the asset price bubble could easily emerge (Iwata (2006)). The housing loans provided by the Public Housing Finance Corporation (PHFC) suffered losses due to massive prepayment during the periods of declining interest rates. Iwata and Hattori (1999) estimated prepayment costs amounting to ¥215 billion, based on the model of the call option premium attached to housing loans provided by the PHFC. Now the risk of prepayment is borne by investors, instead of taxpayers, through securitizing the housing loan by the new corporation after the abolition of the PHFC. In addition, real estate-related loans by unsupervised non-banks (the special housing finance companies) increased massively. It seems noteworthy that the policy measure limiting real estate-related loans in 1990 ultimately put an end to the land price bubble. 14. At this Jackson Hole conference in 1999, Chairman Bernanke and Prof. Gertler argued that the adoption of a "flexible inflation targeting" policy may have prevented both the emergence of the asset price bubble at an early stage and the financial instability at a later stage, even though the monetary policy had not directly targeted asset prices. Former Deputy Governor Yamaguchi (1999) commented on their paper, saying that, "I don't see how a central bank can increase interest to 8 or 10% when we don't have inflation at all". Giavazzi and Mishkin (2006) also pointed out that, "the serious mistake that a central bank makes is not failing to stop a bubble, but is rather not responding fast enough after a bubble bursts". 6 15. I feel inclined towards the indirect approach to asset prices; namely that monetary policy should be oriented toward enhancing price stability and smoothing fluctuations in GDP gap, while refraining from targeting asset prices directly, given the limited knowledge to correctly detect fundamental asset prices. There are a number of hurdles before a direct or preemptive approach can be adopted. These include the identification of a bubble, serious macroeconomic consequences (such as a severe financial crisis after the bubble bursts), the adequacy of using interest rate policy to deflate the bubble, and public support. However, I am not yet fully convinced by the argument that all the problems Japan faced at that time would have been solved by the adoption of a flexible inflation targeting policy alone. Lessons from the asset price bubble of the 1980s 16. Now let me draw several lessons from the boom and bust of asset prices in the latter half of the 1980s. First, we should give priority to price stability as a policy objective over the apprehension of exchange rate fluctuations and the external imbalance. At that time, Japan's current account surplus, coupled with the U.S. deficit, was perceived to be one of the major macro-economic policy issues, although the theoretical underpinning for rectifying the external imbalance was not solid enough. 7 Moreover, a proposal on targeting the exchange rate was seriously debated in an attempt to solve the current account imbalance. 8 Giavazzi and Mishkin further mentioned, as the second lesson, the procrastination on the part of the Japanese government in restoring the health of the financial system after the bubble burst. Iwata (1991) carried out a simulation exercise on the future development of the U.S.-Japan external imbalance based on the overlapping generations model in an open economy. The simulation results showed the possibility of long-sustained imbalance until the mid-2020s, mainly reflecting economic fundamentals such as the difference between the two countries in saving ratio, productivity and population growth rate. According to Prof. Taylor (2007), the exchange rate policy of the U.S. government is today guided by several principles: (1) it must be supported by sound domestic policies, (2) it should rely on markets with a minimum of intervention, (3) it should minimize verbal intervention, (4) there is a need for a financial diplomacy strategy, and (5) it should take due account of international political and security issues. These principles, notably the second principle, seem to be different from the exchange rate targeting proposal. Prof. McCallum regards the separation by government of exchange rate policy and monetary policy as an anachronism, because of the linkage of exchange rate and interest rates within the general equilibrium framework. 17. Second, we should put emphasis on the need to deal with the euphoria brought about by higher expected growth and the sharp drop in "finance premium" during the bubble period. The increasing collateral value compressed the finance premium for real estate and corporate borrowing. The aggressive risk-taking was facilitated by financial deregulation and the higher expected growth rate under price stability, in part due to mistaken perceptions of future technological progress (Figure 7). 18. Today, we see a similar problem with low term- and risk premia, which constitute one of the causes of the "conundrum of global low long-term interest rates". We observe that the real long-term interest rate among major advanced economies has tended recently to converge at around 2% (Figure 8). Given the low term- and risk premia across various financial markets, the low real long-term rate implies that any country which has higher expected growth rate, significantly above 2%, is liable to register the acceleration of asset prices. 9 19. Third, it may be useful to extract a signal or guide to future price developments from asset price changes by examining the factors and the sources of asset bubbles, to the extent that there exist various distortions and imperfections in financial markets. Although it may be desirable to have an intertemporal cost of living index, this might not help us in the near future. It is possible instead to show the likely consequence of deviation of asset price from the historical trend or the simulated fundamental price based on models. It is interesting to note that the OECD (2005, 2006) identified the deviation of the actual rent-to-price ratio from the fundamental ratio based on the long-term historical average ratio, employing the inverse of user cost as a proxy to the price-to-rent ratio, as the user cost equates the expected cost of owning a house with the cost of renting. Further, the OECD estimated the nearing of a peak to real house prices, if interest rates were to rise further. 20. Fourth, prudential policy is required in order to avoid the financial instability arising from a boom and bust in asset prices. Such policy can contribute to preventing excessive risk-taking by financial institutions; it may be appropriate to strengthen the monitoring of unsupervised non-banks. In the case of sub-prime loans in the U.S., more than half of the loans were provided by unsupervised mortgage companies. The stress test on the above-trend rise in land prices and the decline to the trend can be used to indicate future damage to the financial system. The credit risk was estimated to amount to about ¥22.8 trillion at the end of March 1990 under the assumption of a bursting bubble and a deterioration in the credit situation of the related industries (Shimizu and Shiratsuka (2000)). The publication of "Financial System Report" may serve to send warning signals on excessive risk-taking by financial institutions. An alternative explanation of the conundrum attributes it to the "global saving glut". The real long-term interest rate largely reflects the global saving-investment balance. This begs the following question; to what extent does the saving-investment balance deviate from the equilibrium balance? For instance, corporate managers in advanced economies behave rather cautiously on the expansion of business investment despite ample corporate savings. China seems to expand fixed investment in an excessive manner, yet domestic savings exceeds domestic investment. In both cases it seems difficult to identify the degree of excess saving. On the relationship between real economic activity and asset prices, there is a tendency for the boom and bust in business fixed investment to be associated with boom and bust in land prices. Actually the elasticity of substitution of capital for land is greater than one in postwar Japan. Yet the movements in land prices explain little in the movements of business fixed investment (Kiyotaki and West (2004)). Conclusion 21. Given the asset price boom and bust in the latter half of the 1980s, and the subsequent persistent deflation after 1998, the "new policy framework for the conduct of monetary policy" was announced in March 2006. Aside from the first perspective, which examines the likely development within forecast period, the new policy framework incorporated as a second perspective an examination of potential risks beyond the forecast period. Today, we observe that land prices have bottomed out with the significant rise in the price of commercial land, while the core CPI hovers around zero against a background of rising utilization ratio and a tightening of labor market conditions. We must recall that behind the aggressive risk-taking in the latter half of the 1980s there was the market perception of long-sustained low interest rates for the future under price stability. It may be useful to carry out an exercise to demonstrate the consequences of long-sustained low interest rates and the financial imbalance on the future development of economic activity and prices. This may further clarify the role and merits of the two perspectives in our new policy framework. References [1] Alchian, A., and B. Klein, "On a Correct Measure of Inflation," Journal of Money, Credit and Banking, February 1973, pp. 173-191. [2] Bernanke, B., and M. Gertler, "Monetary Policy and Asset Price Volatility," Economic Review, Federal Reserve Bank of Kansas City, Fourth Quarter, 1999. [3] Eiglsperger, M., "The Treatment of Owner-Occupied Housing in the Harmonized Index of Consumer Prices," ifc Bulletin, No. 24, August 2006, pp. 68-79. [4] Fisher, I., "Nature of Capital and Income," New York, 1906. [5] Giavazzi, F., and F. Mishkin, "An Evaluation of Swedish Monetary Policy between 1995 and 2005," Report published by the Riksdag (Swedish parliament) Committee on Finance, 2006. [6] Girouard, N., M. Kennedy, P. Noord and C. Andre, "Recent House Price Developments: The Role of Fundamentals," Economics Department Working Papers No. 475, OECD, 2006. [7] Hayek, F. A., "Full Employment at Any Price?" The Institute of Economic Affairs, 1975. [8] Iwata, K., "Budgetary Balance, Aging, and External Balance: The Future of the United States-Japan External Imbalance," Journal of the Japanese and International Economies, Vol. 5, 1991, pp. 473-497. [9] Iwata, K, "Stock Economy and the Tax System," (ed.) Yukio Noguchi, Economic Analysis of Stock Economy, Nihon Keizai Shimbunsha, 1992 (in Japanese). [10] Iwata, K., "The Role of Money and Monetary Policy in Japan," Remarks at the Fourth ECB Central Banking Conference, Frankfurt, November 10, 2006. [11] Iwata, K., and T. Hattori, "Prepayment and the Call Option Premium," Quarterly Journal of Housing and Land Economies, No. 32, 1999, pp.10-21 (in Japanese). [12] Iwata, K., and T. Hattori, "Fewer Children, Aging and Land Prices Prepayment," Quarterly Journal of Housing and Land Economies, Vol. 50, 2003, pp. 2-7 (in Japanese). [13] Kanoh, S. and H. Murase, "On Land Price Formation: Bubble vs. Option," The Japanese Economic Review, Vol. 50, No. 2, 1999, pp. 212-226. [14] Kiyotaki, N., and K. West, "Land Prices and Business Fixed Investments in Japan," NBER Working Papers No. 10909, 2004. [15] McCallum, B., "Monetary Policy in East Asia: The Case of Singapore," IMES Discussion Paper Series, No. 2007-E-10, Bank of Japan, 2007. [16] Noord, P., "Are House Prices Nearing a Peak? A Probit Analysis for 17 OECD Countries," Economics Department Working Papers No. 488, OECD, 2006. [17] Pavlov, A., and S. Wachter, "The Inevitability of Marketwide Underpricing of Mortgage Default Risk," Real Estate Economics, Vol. 34, No. 4, pp. 479-496, 2006. [18] Shibuya, H., "Dynamic Equilibrium Price Index: Asset Price and Inflation," BOJ Monetary and Economic Studies, Vol. 10, No. 1, February 1992, pp. 95-109. [19] Shimizu, T., and S. Shiratsuka, "The Credit Risk of Japanese Banks during the Bubble Period: A Pilot Study of Macro Stress Simulation," IMES Discussion Paper Series, No. 2000E-31, Bank of Japan, 2000. [20] Shiratsuka, S., "Asset Price Fluctuation and Price Indices," Monetary and Economic Studies, Vol. 17, No. 3, December 1999, pp. 103-128. [21] Taylor, J., "Global Financial Warriors," Norton, 2007. [22] Yamaguchi, Y., "Asset Price and Monetary Policy: Japan's Experience," Remarks at a symposium sponsored by the Federal Reserve of Kansas City in Jackson Hole, Wyoming, August 26-28, 1999.
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Summary of a speech by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, at the Spring Meeting of the Japan Society of Monetary Economics, Chiba, 12 May 2007.
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Toshiro Muto: How do central banks make decisions? – monetary policy by committee Summary of a speech by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, at the Spring Meeting of the Japan Society of Monetary Economics, Chiba, 12 May 2007. * * * Introduction I am honored to have this opportunity to address a society with such a long-standing tradition. Today, I would like to elaborate on central banks' decisionmaking process, especially that by committee. Although policy changes by the Bank of Japan attract a lot of attention, I believe that the decisionmaking process, in which policy is decided by a majority vote of the Policy Board, is not widely understood. For example, according to the Results of the 23rd Opinion Survey on the General Public's Views and Behavior conducted by the Bank in June 2005, over half of the respondents answered that they had never heard that "monetary policy aimed at maintaining price stability is conducted based on decisions made at the Bank's Monetary Policy Meetings." The Bank has adopted a committee structure in which decisions are made by a majority vote of the members of the Policy Board. Based on the Bank of Japan Law, which was revised in 1997 and came into effect in April 1998, the Policy Board – the highest decisionmaking body of the Bank – decides on a wide range of matters, not only those related to monetary policy but also those related to financial stability and the payment and settlement system. Policy Board meetings where monetary policy is deliberated and decided are called Monetary Policy Meetings (MPMs). Many other central banks have also adopted a committee structure in making monetary policy decisions, such as the Federal Open Market Committee (FOMC) of the Federal Reserve System for the United States, the Governing Council of the European Central Bank (ECB) for the euro area, and the Monetary Policy Committee (MPC) of the Bank of England (BOE) for the United Kingdom. I. The quiet revolution: decisionmaking by committee A. Overview One of the issues in which academic researchers have shown an increasing interest in recent years is monetary policy decisionmaking by committee. Professor Alan Blinder at Princeton University, a former Vice Chairman of the Board of Governors of the Federal Reserve System during Chairman Greenspan's era, has highlighted a "quiet revolution" in central banking practice in the past decade: namely, changes in the areas of decisionmaking by committee, transparency, and communication with the market. 1 Decisionmaking by committee requires deliberations among committee members and collective decisionmaking. The committee structure is not necessarily unique to central banking. For example, in Japan, the Diet has standing and special committees, and the government also has independent committees such as the Fair Trade Commission. Furthermore, some corporations have adopted a committee structure. See Blinder (2004). Is decisionmaking by committee superior to that by an individual? Intuitively, in line with the saying "two heads are better than one," groups might come up with better ideas than an individual. It seems to me that deliberations among multiple individual members with expertise and diverse insights should lead to a better policy outcome. In other words, through deliberations members can share their knowledge and skills and correct each other's misunderstandings, and the shortcomings of individual decisionmaking such as one-sided or prejudiced views, a lack of multifaceted consideration, and dogmatic attitudes can be greatly reduced. Professor Stephen Bainbridge of the UCLA School of Law has studied collective decisionmaking by the boards of directors of U.S. corporations. 2 He refers to the issue of "bounded rationality" as one explanation of why decisionmaking by group is advantageous and argues the following: "Decisionmaking requires the use of scarce resources for four purposes: observation, or the gathering of information; (2) memory, or the storage of information; (3) computation, or the manipulation of information; and communication, or the transmission of information . . . If groups have an advantage relevant to the institution of the board of directors, it therefore seems most likely to arise with respect to either memory and/or computation . . . Put another way, group decisionmaking may be an adaptive response to bounded rationality, creating a system for aggregating the inputs of multiple individuals with differing knowledge, interests, and skills." B. Research on central banks' decisionmaking by committee Next, I would like to refer to some of the literature that specifically analyzes central banking and monetary policy decisionmaking by committee. 3 Professor Blinder discusses whether monetary policy should be made by an individual or a committee and explains why the central banks of many countries have now adopted committee decisionmaking as follows: 4 "I believe that the main factor underlying the worldwide trend toward monetary policy committees . . . was the perceived success of the Federal Reserve and the Bundesbank, both of which had long made decisions . . . by committee. Imitation is, after all, the sincerest form of flattery. In addition, there is no reason to have a monetary policy committee when the central bank is simply taking orders from its government. So the trend toward central bank independence opened the door to committee decisionmaking." In addition, Professor Blinder summarizes the main arguments for preferring committee to individual decisionmaking under the following four points, 5 which seem to be consistent with the study on the boards of directors of U.S. corporations that I have just referred to. 1. "Pooling: A committee pools the disparate knowledge of its individual members. 2. Diversity: Members of a committee bring different decisionmaking heuristics to a complex problem. See Bainbridge (2002). See Fujiki (2005) for references to the related literature. See Blinder (2006a, b). See Blinder (2006b). 3. Checks and balances: Committees are less likely to adopt extreme or idiosyncratic positions. 4. Reduced volatility: Owing to “averaging” (which need not be interpreted literally), the decisions of a group are likely to be less volatile." With regard to the fourth point, however, Professor Blinder argues that it "might conceivably be turned around and viewed as a vice instead because one person's low volatility is another's excessive inertia." Professor Anne Sibert of the University of London notes free riding and group polarization as possible shortcomings of group decisionmaking. 6 With regard to the first issue, she points out that the free-riding problem can occur, for example, in gathering information and that larger committees are more likely to encounter this problem than smaller committees. However, I do not believe that the free-riding problem is likely to emerge in decisionmaking in committees based on my experience at the Bank, where each member participates in the decisionmaking autonomously and independently. With regard to the issue of group polarization, biased group membership and heated deliberations make the views of individual members less moderate or more extreme. Group polarization can be inconsistent with excessive inertia, which is noted by Professor Blinder. Professor Sibert also says that it is debatable whether moderation or polarization is a good thing. In my experience, group polarization is unlikely to occur if members of the committee have profound experience and diversified backgrounds. Summarizing what I have referred to and mentioned so far, the committee structure can be a better framework for decisionmaking because of the pooling of knowledge, the diversity of views, and the checks and balances it provides, and such group decisionmaking can be superior to individual decisionmaking. However, it should be noted that in practice, group decisionmaking can be excessively inert and the adoption of the committee structure does not necessarily guarantee the right outcome. II. The committee’s structure of the FOMC, the Governing Council, and the MPC I will briefly explain how other central banks reach their decisions under the committee structure. I would like to discuss the FOMC of the Federal Reserve System, the Governing Council of the ECB, and the MPC of the BOE. A. The FOMC The FOMC consists of twelve members: seven members of the Board of Governors of the Federal Reserve System, including the Chairman and the Vice Chairman, and five Reserve Bank presidents, of whom four serve on a rotating basis. The other seven presidents also attend FOMC meetings and participate in the discussions, although they do not have the right to vote. Members of the Board of Governors are nominated by the President of the United States and confirmed by the Senate. In making appointments, the President needs to pay due regard to a fair representation of financial, agricultural, industrial, and commercial interests, and the geographical division of the country. On the other hand, the president of each Reserve Bank is nominated by its board of directors. The nomination process is such that members of the FOMC would have diversified knowledge and insights. In fact, current members have diverse career backgrounds as, for example, academics, executives of financial institutions, highranking officials of international organizations, government officials, and central bankers. See Sibert (2006). With regard to terms of office, members of the Board of Governors have full terms of 14 years and Reserve Bank presidents have five years. Transcripts of FOMC meetings reveal that members present various opinions, hold lively discussions, and make decisions by majority vote. Mr. Meyer, a former member of the Board of Governors during Chairman Greenspan's era, noted that there were two traditions at the FOMC: the first was that the Chairman was always expected to be on the winning side of a policy vote, and the second was that the FOMC strove to reach a consensus on the policy decision. 7 However, votes have not always been unanimous and one or two dissenting votes are not unusual. In fact, during the second half of 2006, Mr. Lacker, the president of Federal Reserve Bank of Richmond, dissented because he believed that further policy tightening was needed. B. The Governing Council The Governing Council of the ECB consists of 19 members: six members of the Executive Board, including the President and the Vice President, and the governors of 13 national central banks in the euro area. The number of euro area countries has increased from twelve to 13 with Slovenia joining at the beginning of 2007. Members of the Executive Board are appointed – from among persons of recognized standing and professional experience in monetary or banking matters – by the European Council, following necessary procedures. The governors of national central banks are appointed in accordance with national laws. The 19 members of the Governing Council, with diverse nationalities, have a wide variety of career backgrounds, including as academics, executives of financial institutions, politicians, government officials, and central bankers. Accordingly, reflecting historical and institutional factors unique to Europe, the Governing Council is a group of experts with diversity, selected in consideration of expertise and geographical factors. Members of the Executive Board of the ECB have eight-year terms, and the governors of national central banks, depending upon national laws, have terms of five years or more. It is often said that the consensus of the Governing Council in decisionmaking is respected and that its decision is the result of collective deliberation and debate. 8 C. The MPC The MPC consists of nine members: five internal members, that is, the Governor, the two Deputy Governors, the Bank's Chief Economist, and the Executive Director for Markets (the latter two are appointed by the Governor upon consultation with the Chancellor of the Exchequer), as well as four external members appointed directly by the Chancellor of the Exchequer. External members are not necessarily full time, and, for example, some members are concurrently faculty members at universities. Current members have diverse backgrounds, including as academics, government officials, private-sector economists, and central bankers. The Governor and the Deputy Governors have five-year terms, and the others have three-year terms. At MPC meetings, dissenting votes are cast rather frequently. Sometimes there are four dissenting votes out of nine. For example, at the January 2007 meeting, the MPC decided to raise the policy interest rate by a 5-4 majority vote. Governor King was in the majority while Deputy Governor Lomax and Messrs. Bean and Tucker were in the minority. Votes among external members were three in favor of the raise and one against, and among internal members, two were in favor and three against. Moreover, at the August 2005 meeting, the See Meyer (1998). See Issing (2005) and Schill (2005). MPC decided to reduce the policy interest rate by a 5-4 majority vote, and this time, Governor King was in the minority. All four votes of external members were in favor of the reduction while votes among internal members were split: one in favor of the reduction and four against. Interestingly, Governor King later testified before the Treasury Committee of the House of Commons on November 24, 2005, saying as follows: "[T]he decision falls out by majority vote . . . it logically follows, as night follows day, that there will be some times when each and every member of the Committee may find themselves in a minority, including the Governor, and I was in that position . . . I felt comfortable about that . . . We believe that the right thing is that at the end everyone says what they honestly believe is the right thing to do." The FOMC of the Federal Reserve System, the General Council of the ECB, the MPC of the BOE, and the Policy Board of the Bank of Japan have all adopted the committee structure, but the design and implementation of the committee structure of each of these differ, partly due to political and historical factors. Each central bank has been making various efforts to improve its implementation to the extent possible. III. The framework and procedures of MPMs Next, I would like to turn to the case of the Bank of Japan and explain the framework and procedures of MPMs. 9 A. The framework of MPMs Monetary policy is deliberated and decided by the Policy Board at MPMs. The Policy Board is composed of nine members: the Governor, the two Deputy Governors including myself, and six other members. Members are all appointed by the Cabinet and approved by the Diet and serve for five-year terms. Under the old Bank of Japan Law of 1942, the Policy Board consisted of a total of seven members: the Governor, four appointed representatives with outstanding experience in the fields of finance, commerce and industry, and agriculture, and two government representatives without the right to vote. The Bank of Japan Law of 1997 stipulates that the six members other than the Governor and the two Deputy Governors be appointed from "among those with academic expertise or experience including experts on the economy or finance." Indeed, Policy Board members come from quite diverse backgrounds and include former academics, executives of corporations as well as financial institutions, and private-sector economists. The number of members of the Bank's Policy Board is nine, which is the same as that of the MPC of the BOE, but it is smaller than the FOMC of the Federal Reserve System and the Governing Council of the ECB. According to a survey on central bank laws conducted by the staff of the International Monetary Fund (IMF), most central bank committees have seven to nine members. 10 If the size of a committee is too small, the accumulation of knowledge becomes difficult, there is less diversity in perceptions and opinions, and checks and balances may not function well. On the other hand, if the size is too big, discussions become less productive. For extensive and constructive discussions where Policy Board members are given sufficient time to express their views, I believe the current size of nine members is within the appropriate range for a committee. At MPMs, the Governor and the Deputy Governors independently express their assessment on the economic and financial situation and their views on the conduct of monetary policy. See Fujiwara (2003). See Lybek and Morris (2004). The Governor and the Deputy Governors are also responsible for carrying out decisions of the Policy Board, together with the Executive Directors and the staff. The six other Policy Board members are full-time executives. In addition to MPMs, they attend Policy Board meetings that make decisions, with the Governor and the Deputy Governors, on important policy issues, such as those on financial stability, business operations, and management strategy. Given that they hold important positions that require neutrality, they are prohibited from taking another occupation, and restrictions are also placed on the types of financial assets they can hold and the financial transactions they can make, as in the case of the Governor and the Deputy Governors. MPMs, where the Policy Board decides a guideline for money market operations for the intermeeting period ahead and formulates the Bank's view on recent economic and financial developments, are held regularly, once or twice a month. Aside from these meetings, Policy Board meetings where the Bank's business operations, management strategy, and other issues are decided are, as a general rule, held twice a week. B. Preparations for MPMs Let me describe how Policy Board members prepare for MPMs. Policy Board members accumulate various types of information useful for the Bank's conduct of monetary policy through their analysis of the economic situation and financial market developments, the daily conduct of business operations, and exchanges of views with representatives from various fields. Utilizing such information as well as knowledge, Policy Board members monitor carefully economic and financial developments. The details of the preparation for MPMs are as follows. At least two business days prior to the MPM concerned, Policy Board members are provided with written reports prepared by the Bank's staff, which the Bank's staff later use at the beginning of the meeting to present an assessment of the current economic and financial situation. The reports include a comprehensive analysis of the economy based on available macro and micro economic information. In preparation for the MPM, members read through the staff's reports and formulate their views on the economic and financial situation, the outlook, and the appropriate direction of monetary policy. C. Deliberations on the day of the MPM I will now outline a typical two-day MPM. The first day of the MPM usually starts at 2:00 p.m. The meeting is attended by Policy Board members and by government representatives, namely, the Minister of Finance and the Minister of State for Economic and Fiscal Policy or their designated delegates. Executive Directors of the Bank in charge of departments directly concerned with monetary policy, and Directors-General and other senior officials of departments concerned, attend MPMs to report. Others present at the MPM include staff of the MPM secretariat supporting the proceedings of MPMs. The chairman of the Policy Board is elected by the Board members from among themselves. The Governor has so far always been the chairman. On the first day of the MPM, the staff present reports on recent economic and financial developments. Specifically, the staff report developments including the results of the Bank's money market operations and developments in the economy and financial markets in Japan as well as those abroad. The meeting then moves on to a question-and-answer session between Policy Board members and the reporting staff. The second day of the MPM usually starts at 9:00 a.m. The meeting begins with a discussion among Policy Board members on economic and financial developments. First, each Policy Board member in turn expresses his or her views on recent economic and financial developments and the prospects for the future, taking into account the reports presented by the Bank's staff on the previous day and other members' views. After all the members have had their turn, discussion starts and members freely and actively exchange views on economic and financial developments. Following the discussion on economic and financial developments, Policy Board members next discuss the conduct of monetary policy. Again, each Policy Board member in turn expresses his or her views, mainly on whether the Bank should maintain or change the guideline for money market operations for the intermeeting period ahead, and the reasons. Furthermore, Policy Board members deliberate on the Bank's conduct of monetary policy in the longer term. Members then exchange views freely to gain a better understanding of each other's views and differences in their views, and proceed further with the discussion. In the course of the discussion, government representatives have an opportunity to make remarks. D. Votes on policy decisions at MPMs After the thorough discussions, Policy Board members take a vote on the policy proposal relating to the guideline for money market operations for the intermeeting period ahead, i.e., whether the Bank should change or maintain the guideline for money market operations. Based on the intensive discussions among Policy Board members at the MPM, the chairman formulates and submits a policy proposal that reflects the majority view of the members. As I mentioned earlier, sometimes other Policy Board members who hold different views submit a proposal separately. The decision is made by a majority vote. This is the process of how the guideline for money market operations for the intermeeting period ahead and the release of public statements, which is also put to the vote, are decided. After the guideline for money market operations for the intermeeting period ahead is decided, Policy Board members discuss "The Bank's View" of recent economic and financial developments as well as the outlook, which is published in the Monthly Report of Recent Economic and Financial Developments. The draft of "The Bank's View" is formulated based on the members' discussion and put to the vote. Looking back at past MPMs, votes have not always been unanimous. Since my inauguration as Deputy Governor in March 2003, I have attended 63 MPMs up to this April. Among these, the number of MPMs where votes were cast against the chairman's policy proposal on the guideline for money market operations was as follows: two MPMs with three dissents, 15 MPMs with two dissents, and five MPMs with a single dissent. Moreover, there were 24 proposals other than the chairman's on the guideline for money market operations: at seven MPMs there were two proposals other than the chairman's, while at ten, there was one proposal other than the chairman's. There were five MPMs where dissents were cast against the chairman's proposal without the submission of any other proposal. The fact that votes at MPMs have not always been unanimous suggests that the autonomy of each Policy Board member has been respected. E. Announcement of decisions After going through the above decisionmaking process, the MPM finally comes to a close. Policy Board members are provided with sufficient time to hold extensive discussions and the decisions made at MPMs are announced so that Japanese financial markets can as much as possible digest the decisions on the day of the meeting. The guideline for money market operations decided at the MPM is announced immediately after it ends, and the Governor holds a press conference on that day, usually from 3:30 p.m. To avoid confusion in financial markets, Policy Board members have agreed to comply with the so-called blackout rule, which sets a period starting from two business days before an MPM and lasting until the end of the Governor's press conference. During this period, members must, as a general rule, refrain from making public comments on monetary policy and economic and financial developments. IV. Decisionmaking by committee and central bank independence Next, I would like to turn to the relationship between decisionmaking by committee and central bank independence. As previously noted, Professor Blinder makes the interesting point that "[w]hen the central bank was just following orders communicated by the government, there was not much reason to have a committee . . ." 11 However, a committee structure is not a necessary and sufficient condition for a central bank to maintain its independence from the government. More important is the concrete relationship between the central bank and the government. I will not go into central bank independence in depth today, but will elaborate on the following points in relation to the committee structure: the significance of independence for the Bank of Japan; the guarantee of the status of Policy Board members; and the attendance of government representatives at MPMs. First, the Bank's independence regarding the conduct of monetary policy, which is referred to as "autonomy" in the Bank of Japan Law of 1997, has been strengthened since 1998, when the Law came into effect. Although the Bank remains to a certain degree under the government's control as a public organization, it is granted by the Bank of Japan Law the explicit mission to conduct monetary policy in pursuit of price stability, and thus the Policy Board can make monetary policy decisions independently without external interference. Second, in order to ensure the independence of the Bank, Policy Board members' term of office is set as five years and during this term their status is guaranteed, with causes for dismissal limited to, for example, physical or mental disorders. Third, the attendance of government representatives at monetary policy committees varies according to central banks. At the Federal Reserve System, government representatives are not allowed to attend FOMC meetings. At the ECB, the President of the ECOFIN Council and a member of the European Commission (usually the Commissioner responsible for Economic and Monetary Affairs) often attend the Governing Council meetings. At the BOE, a representative from the Treasury attends MPC meetings. As for the Bank of Japan, government representatives attend MPMs, as in the case of the ECB and the BOE. The Minister of Finance and the Minister of State for Economic and Fiscal Policy or their designated delegates attend MPMs, as specified in the Bank of Japan Law. They express their views on the state of the economy, the government's conduct of economic policy, and the Bank's conduct of monetary policy. Although the government representatives do not have the right to vote, they can submit a proposal requesting to postpone the Policy Board members' vote on policy proposals to the next MPM. Such a proposal was in fact presented at the MPM in August 2000. Moreover, government representatives can submit a proposal for monetary policy measures to be decided by the Policy Board. In both cases, it is up to the Policy Board to decide whether to adopt any proposal submitted by government representatives. In short, the Bank of Japan Law sets forth a transparent framework to facilitate the exchange of views between the Bank and the government and to ensure the opportunity for the government to express its opinion concerning monetary policy at MPMs, thereby ensuring both central bank independence and consistency between the Bank's monetary policy and the government's economic policy. V. Decisionmaking by committee and central bank transparency Next, I would like to turn to the relationship between decisionmaking by committee and central bank transparency. I will start by describing the communication frameworks regarding See Blinder (2006a). policy decisions at the FOMC of the Federal Reserve System, the Governing Council of the ECB, the MPC of the BOE, and the Policy Board of the Bank of Japan. A. Transparency of monetary policy decisions The FOMC releases a statement concerning the decision made at the meeting on the same day. The statement contains the Committee's basic view of the U.S. economy, the Committee's decision regarding monetary policy, and the result of members' vote on FOMC monetary policy action. The minutes of FOMC meetings are released three weeks after the date of the policy decision, and transcripts of meetings are released with a five-year lag. The Governing Council does not release its minutes, transcripts, or details of members' votes. After the Governing Council meeting, the President, assisted by the Vice-President, holds a press conference. The President makes an introductory statement, explaining the decision as well as the economic and monetary analysis, and this is then followed by a question-and-answer session. The MPC announces its interest rate decision immediately following the MPC meeting. The minutes of the MPC meetings are published two weeks after the interest rate decision. The record of the votes of the individual members of the Committee is released in the minutes. As for the Bank of Japan, the Policy Board announces, immediately after the MPM, the decision on its guideline for money market operations for the intermeeting period ahead. Since the MPM in February 2007, the record of the votes of the individual Policy Board members has also been released in the announcement of MPM decisions. Shortly afterward on the same day, the Bank publishes "The Bank's View" in the Monthly Report of Recent Economic and Financial Developments, and the Governor holds a press conference. The minutes of MPMs are released around one month after the meeting concerned, and the transcripts of MPMs are to be published ten years later. The Bank also releases the Outlook for Economic Activity and Prices semiannually (the April 2007 issue was released recently). In addition, the Governor reports to and attends the Diet, and Policy Board members frequently give speeches and accept interviews. B. Central bank communication with the market Another important issue is how central banks adopting the committee structure should communicate with the market. Given that the effects of monetary policy are transmitted via financial markets, enhancing transparency not only ensures the central bank's accountability to the public but also improves the effectiveness of monetary policy. However, enhancing the transparency of policy decisionmaking by committee involves difficult issues, unlike the case of individual decisionmaking where only one individual needs to be accountable for his/her decisions. Central banks that adopt decisionmaking by committee need to seek ways to enhance the accountability of the committee as a whole as well as that of each individual member, including the governor as the chairman. This issue of accountability also relates to central bank communication with the market and poses a difficult problem. In 2000, the third year since the establishment of the MPC, the BOE asked the Vice Chairman of the Board of Governors of the Federal Reserve System, Mr. Kohn, who was then the Director of the Division of Monetary Affairs, to assess the transparency of the policymaking process at the MPC. One of Mr. Kohn's assessments was that "the committee structure greatly complicates transparency; it is far easier to determine and publish the views of a single person than it is those of a Committee with nine individually accountable members." 12 The response of the MPC was that "this is particularly true of one important See Kohn (2000). theme which runs through the Report, namely the problem of reconciling individual accountability of MPC members with the need to present a collective message to the public that explains the decisions of the Committee." 13 To deal with this problem, the ECB has "placed a premium on speaking “with one voice” and consensus in decisionmaking." 14 This reflects the need to conduct a single monetary policy in the euro area in the unique environment of European integration. A typical example of speaking "with one voice" is the press conference by the President held shortly after the monetary policy decision. Mr. Trichet, the President of the ECB, has often emphasized that it is his role as the captain to speak "with one voice" on behalf of all members of the Governing Council of the ECB. On the other hand, with a view to enhancing the transparency of policy decisionmaking based on the committee structure, the FOMC, the MPC, and the Policy Board of the Bank of Japan release the results of the votes of individual members, thus indicating the existence of minority views, and have also made efforts to release the minutes of the meetings sooner. In addition, like the President of the ECB, the Governor of the Bank of Japan holds a press conference after the MPM on the same day to enhance transparency of monetary policy decisions. While it is important to secure an environment where members can contemplate and hold extensive discussions at meetings in order to maximize the merits of the committee structure, at the same time the transparency needs to be enhanced, and it is therefore important to strike a balance between them. In the case of the Bank of Japan, I believe that through the release of the minutes and transcripts of MPMs, Policy Board members are all the more responsible for the persuasiveness and the consistency of their remarks, and thus the quality of deliberations at MPMs has also been improved. In sum, the Bank of Japan's Policy Board has a highly transparent framework and is unique in that transparency is ensured both through a press conference held by the Governor after every MPM on the same day and the release of the minutes and the transcripts of MPMs by the Bank. The Bank will continue to make every effort to enhance transparency so as to improve its accountability to the public and the effectiveness of monetary policy. C. Lessons learned from recent experience In connection with the February policy change, there is criticism that there may have been some confusion in the process of communicating with the market since the end of last year, when the policy action began to be the target of speculation. We accept such criticism and will try to improve the means of communication in the future. I would like to express my views on the Bank's communication with the market before and after an MPM in relation to the committee structure I explained earlier. First, it should be made clear that information concerning the results of the policy decisions is never released by the Bank before an MPM. At MPMs, policy decisions are made by vote after thorough discussions among members. Some members may change their views as a result of the discussions, and therefore policy decisions are unknown until a vote is taken. Second, immediately following an MPM, the Bank disseminates information on the policy decision through various communicative media that are all easily accessed by the general public. The Bank announces the guideline for money market operations, the Governor holds a press conference, and the Monthly Report of Recent Economic and Financial Developments and the Outlook for Economic Activity and Prices are released. Moreover, if See Bank of England (2000). See Issing (2005). some members have voted against a policy proposal that represents the majority view, their views, in addition to the majority view, are clearly explained, for example, in the minutes of the MPMs. I believe that the process of discussions held at the MPMs has been made more transparent through the publication of minority views, and that, as a result, the policy stance and the intentions of the Bank have been made clearer. Third, I believe there are two key types of information that a central bank needs to provide: the central bank's assessment of the economic and price situation; and its basic thinking on the conduct of monetary policy. Market participants can form expectations regarding future interest rates by adjusting their views of the economy and prices on the basis of such information, while central banks can deduce market participants' views regarding the economy and prices from market interest rates and yield curves. What we have in mind in terms of communicating with the market is such a two-way exchange of information. Hinting at the actual timing of the policy change is generally inadvisable. If such a hint were made, market participants would carry out transactions based not on their own views of the economy and prices but in response to the central bank's hint, and this would result in a breakdown of the two-way exchange of information. Concluding remarks As I explained earlier, there are various types of committees. Based on my everyday experience of conducting monetary policy, I believe that the committee structure has proved advantageous and effective in making appropriate monetary policy decisions. In order to take full advantage of the merits of the committee structure, central banks should constantly make efforts to improve the operation of monetary policy committees in line with changes in the environment. Today I expressed my practical views on central banking by committee. I would appreciate it if you, leading economists, could take some of these points into consideration in constructing your economic models and theories in the future. I look forward to learning from the fruits of your new research. Thank you very much for your attention. References Bainbridge, Stephen M., "Why a Board? Group Decisionmaking in Corporate Governance," Vanderbilt Law Review, 55, 2002, pp. 1-55. Bank of England, "Bank of England Response to the Kohn Report," December 6, 2000. [Bank of England, "Bank of England Response to the Kohn Report,"Bank of England Quarterly Bulletin, 41 (1), 2001, pp. 50-54.] Blinder, Alan S., The Quiet Revolution: Central Banking Goes Modern, Yale University Press, 2004. ------, "Monetary Policy by Committee: Why and How?" DNB Working Paper No. 92, De Nederlandsche Bank, 2006a. ------, "Monetary Policy Today: Sixteen Questions and about Twelve Answers," in S. Fernandez de Lis and F. Restoy, eds. Central Banks in the 21st Century: An International Conference Sponsored by Banco de España, Banco de España, 2006b. Fujiki, Hiroshi, "The Monetary Policy Committee and the Incentive Problem: A Selective Survey,"Monetary and Economic Studies, 23 (S-1), Institute for Monetary and Economic Studies, Bank of Japan, 2005, pp. 37-82. Fujiwara, Sakuya, "Inside a Monetary Policy Meeting," speech given at Toyo University on March 13, 2003. Issing, Otmar, "Communication, Transparency, Accountability: Monetary Policy in the Twenty-First Century," Review, 87 (2, Part 1), Federal Reserve Bank of St. Louis, 2005, pp. 65-83. Kohn, Donald L., "Report to the Non-Executive Directors of the Court of the Bank of England on Monetary Policy Processes and the Work of Monetary Analysis," October 18, 2000. [Kohn, Donald L., The Kohn Report on MPC Procedures,"Bank of England Quarterly Bulletin, 41 (1), Bank of England, 2001, pp. 35-49.] Lybek, Tonny, and JoAnne Morris, "Central Bank Governance: A Survey of Boards and Management," IMF Working Paper No. 04/226, International Monetary Fund, 2004. Meyer, Laurence H., "Come with Me to the FOMC," The Gillis Lecture, Willamette University, Salem, Oregon, April 2, 1998. Schill, Wolfgang, "Panelists' Remarks (Concluding Panel Discussion on Incentive Mechanisms for Economic Policymakers: Macroeconomic Policy and Central Banking at the Twelfth International Conference of the Bank of Japan),"Monetary and Economic Studies, 23 (S-1), Institute for Monetary and Economic Studies, Bank of Japan, 2005, pp. 234-239. Sibert, Anne, "Central Banking by Committee,"International Finance, 9 (2), 2006, pp. 145168.
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Speech by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, at the Japan Society, London, 7 September 2007.
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Toshiro Muto: Challenges facing Japan’s economy – a case for structural reform Speech by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, at the Japan Society, London, 7 September 2007. * * * It is my great honor to speak to you today, the esteemed members of the Japan Society. When I was last invited to speak here in 2004, the Japanese economy was just coming out of a protracted downturn after the collapse of the bubble and was at last moving onto a fullfledged recovery path. Japan's economy has since continued its growth and I am happy to report to you today that the recovery, which started in 2002, is now in its sixth year and has become the longest in the postwar era. I. Current economic situation in Japan First, let me briefly discuss the current Japanese economic situation. Japan's economy has been experiencing a sustained period of growth at the rate of around 2 percent, which is slightly above the potential growth rate, supported by strong external demand and stable domestic demand. Conditions in the corporate sector are particularly good. According to the Tankan (ShortTerm Economic Survey of Enterprises in Japan), a business survey conducted by the Bank of Japan, the ratio of firms' current profits to sales is at a record high and corporate fixed investment this fiscal year is likely to register its fifth consecutive year of growth. Those favorable conditions in the corporate sector are gradually but steadily feeding through to the household sector. Although wages are not yet rising, as I will discuss in more detail later, household income is trending upward via several channels, for example, increases in the number of employees and in dividends, and private consumption is steady. Under those circumstances, the utilization of resources such as production capacity and labor is increasing. The unemployment rate has come down to 3.6 percent for the first time in nine years. There are two main factors behind Japan's continued economic growth. The first is growth in exports on the back of the global economic expansion. The extension and deepening of the international division of the production process, particularly in Asia, along with rapid growth in newly industrialized economies, have together greatly contributed to the growth of our economy. The second is the recovery of strength in the corporate sector along with the restoration of stability in the financial system. From the latter half of the 1980s, the formation and subsequent collapse of the economic bubble left firms burdened with excesses in debt, production capacity and labor, and financial institutions with significant holdings of nonperforming loans. Firms have since restructured their business lines and improved their financial standing, while the rate of banks' nonperforming loans has been reduced from a peak of above 8 percent to below 3 percent. I think it is fair to say that those impediments have now mostly been removed. II. The price situation On the price front, there is not yet any evidence of inflationary pressure despite steady growth in the economy. The annual rate of change in consumer prices (excluding fresh food) stayed negative from fiscal 1998 through 2004. Although small but positive in both fiscal 2005 and 2006, the recent figures are again negative, albeit marginally. The absence of inflationary pressure despite steady growth in the economy is one of the distinctive features of the current recovery and also a somewhat puzzling phenomenon. Behind it, I believe, lie three changes affecting the formation of prices and wage-setting. The first is the advance of economic globalization. As globalization proceeds, competition with newly industrialized economies that enjoy lower labor costs has been compelling firms to raise productivity and to retain their restrictive stance on labor costs, together with greater exposure to the discipline of the capital market. The second is the influence of deregulation. Even nonmanufacturing firms, which are relatively unexposed to the global market, find themselves in a fiercely competitive environment as deregulation and realignment of the industry continues. Attitudes on the part of employees could be listed as the third change. Employees, having experienced a protracted period when the employment situation was severe, still tend to prefer stable employment to wage increases. Taking a rather longer perspective, however, the environment surrounding prices is likely to change gradually. First, with the economy continuing to grow steadily, overall supply and demand conditions are likely to tighten. Second, labor market conditions are becoming tighter, as indicated by the decline in the unemployment rate. That will eventually lead to rising wages although this may be gradual. Third, surveys of inflation expectations in the private sector suggest moderate rises in prices ahead. Given those factors, the annual rate of change in our consumer prices is expected to be around 0 percent in the short run, but gradually to rise in the longer run. III. The conduct of monetary policy I will now turn to the conduct of monetary policy. In a situation where prices are not rising while the economy is growing steadily, the Bank has been adjusting the level of interest rates in a gradual manner. Our policy interest rate, the call rate, now stands at 0.5 percent after being raised twice since the termination of the quantitative easing policy in March 2006. The Bank has no plans to abandon this basic idea about the conduct of monetary policy. In other words, while assessing the situation of the economic activity and prices in a forwardlooking manner, if the Japanese economy is deemed likely to follow a path of sustained growth under price stability, the Bank intends to adjust the level of interest rates gradually in accordance with improvements in the economic and price situation. At the Monetary Policy Meeting in August, we decided to keep our policy interest rate unchanged. The Japanese economy is expected to continue to enjoy sustained growth. However, global financial markets have been exhibiting some volatility recently, triggered by the subprime mortgage problem in the United States. Although that seems basically to reflect a reevaluation of risk by investors, we believe that the market situation deserves close attention, along with the global economic developments. We will carefully assess incoming economic data and other information as well as the financial market situation both at home and abroad, so as to ensure appropriate policy decisions. IV. Challenges facing Japan's economy So far, I have explained the path of Japan's economy to date, and also our thoughts on the conduct of monetary policy. I hope that the economy will remain on a stable growth path and will be able to match the UK's record 15-year expansion. However, I am aware that a number of domestic issues, such as the declining birth rate and population aging along with the need for fiscal consolidation, have made some people skeptical about the future of Japanese growth. I will use the rest of my allotted time to talk about three issues, and to explain how they are being dealt with. The first issue is the declining birth rate and the aging population. Although the problem is being experienced by many leading economies, the situation is especially serious in Japan. It is not easy to maintain the pace of economic growth when the working-age population, of those aged between 15 and 64, is decreasing at a rate of nearly 1 percent a year. Under such circumstances, society's key task is to bring those members of the elderly and female population who are willing to work into the workforce. Firms, as a move toward solving the problem, have been diversifying their employment patterns. As a result of such efforts, labor force participation rates among the females and the elderly are increasing and the total number of employees is growing at around 1 percent a year despite the diminishing working-age population. Considering the labor market over the longer term, however, there is evidently a need to start exploring other possible measures to deal with the declining population. For that point, I am informed that the UK has accepted around 6 hundred thousand immigrants in the last three years and they are contributing to the growth of the UK economy. Japan too needs to consider accepting more foreign workers, while paying due attention to its impact on Japanese society as a whole. The second issue is fiscal consolidation. Basically, I believe that it should be carried out in as transparent a fashion as possible. The long-term path of fiscal consolidation and its measures should be spelt out clearly in advance. As for the pace of consolidation, it is important that it should be measured, with each step taken in confidence that the economy remains on a sustainable growth path. That is how fiscal consolidation has proceeded to date. The Japanese government, while establishing a precise target for how much they intend to reduce fiscal expenditure, aims to achieve a surplus on its primary balance by the early 2010s. The primary balance deficit, which expanded to around 6 percent of GDP in fiscal 2003, is expected to fall to around 0.9 percent this fiscal year. Spending on public works for this fiscal year, in particular, has declined to around half its peak in fiscal 1995. The amount of the reduction is large, corresponding to around 4 percent of GDP. Yet even with such steady progress in fiscal consolidation, the public debt, at over 140 percent of GDP, is still the largest among leading economies. The government's next step is to secure a stable reduction of this rate by the mid-2010s. It will be a considerable challenge when social security expenditure is increasing due to the aging population. And additional measures to reduce expenditure and maintain revenue levels, including possible changes in the consumption tax, should be examined, following nationwide discussions. The third issue is the intensification of competition with newly industrialized economies. Particularly during the period after the collapse of the bubble economy when Japan was undergoing heavy economic adjustments, the growing presence of newly industrialized countries tended to be regarded as a threat to Japan's competitiveness. In recent years, however, Japanese firms have become better adapted to the situation and a new international division of the production process, concentrated in Asia, has been established. That is evidenced by the changing composition of Japan's imports from Asian countries. The composition has been gradually shifting away from labor-intensive products, such as clothing and other light manufacturing goods, toward machine products that require a relatively high degree of processing, such as IT-related machinery. Against that background, intra-regional trade has been expanding. Japan has been exporting high-tech parts and importing final goods from Asian countries assembled utilizing the abundant labor force in the area. Direct investment from Japan to Asian countries is increasing as Japanese firms seek to optimize their production processes. The profitability of overseas operations is steadily growing and the positive effects are feeding back to Japan via channels such as investment income and patent royalties. Those transactions appear in the balance of payments as improvements in the balances for income and services, respectively. Bolstered by increasing interest earnings on bonds, the income surplus currently exceeds the trade surplus and makes up over half of the current account surplus (now around 5 percent of GDP). As such, I would like to stress that the relationship between Japan and the rest of the world, especially Asian countries, has outgrown that of mere export competitors and has developed into a mutually constructive relationship operating through a network of supply chain management and direct investment. I have discussed three issues facing Japan's economy. Those are the issues that cannot easily be resolved. However, as I have explained, steady steps are being taken to address them and the results are gradually becoming apparent. I believe that, by pushing ahead with such measures, it is entirely possible for Japan's economy to attain a new era of economic development. The Bank intends to contribute to the process by securing sustained economic growth and price stability through the appropriate conduct of monetary policy. Thank you very much.
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Speech by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, at the reception for the 50th anniversary of the Bank of Japan Representative Office in Hong Kong, Hong Kong, 24 September 2007.
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Toshiro Muto: The 50-year-long good relationship between Hong Kong and the Bank of Japan Speech by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, at the reception for the 50th anniversary of the Bank of Japan Representative Office in Hong Kong, Hong Kong, 24 September 2007. * * * Good Evening. Distinguished Guests, Chief Executive of the Hong Kong Monetary Authority Mr. Yam, Consul-General and Ambassador Mr. Sato, Ladies and Gentlemen, On behalf of the Bank of Japan, let me extend our gratitude to all of you for our long-standing friendship and your cooperation with our Hong Kong Office. In 2004, I was invited to join the Visitors Programme sponsored by the government of Hong Kong, and enjoyed a candid exchange of views with senior officials in the government. The bird's-eye view of Hong Kong's dynamic economic activities which I saw from a helicopter is really unforgettable. Since then, I have felt deeply attached to this great city. By coincidence, this year is also the 10th anniversary of Hong Kong's handover to China. It is my great honor to visit Hong Kong again today, and hold our 50th anniversary reception, celebrating Hong Kong's closer economic ties with the mainland and its prosperity as an international financial centre. Pioneer days of the Hong Kong Office There is an interesting story behind the establishment of the Hong Kong Office. In 1953, four years before the opening of the Hong Kong Office, the Bank planned to open an office in Calcutta, India. At that time, the Indian city was important for Japan as a source of iron ore and cotton. Unfortunately, however, two senior Bank staff sent to Calcutta became ill, probably due to the difference in climate between India and Japan. Hence, the Bank gave up the plan. After this incident, Hong Kong was chosen as the location for the Bank's first representative office in Asia. At the time, Hong Kong was already the information hub in Asia, including China, owing to its trading and financial expertise. In retrospect, the decision was appropriate, given Hong Kong's current prosperity as a leading financial centre in Asia and Oceania. However, the new-born Hong Kong Office faced adverse winds in the early stages. Until the early 1970's, due to lack of diplomatic relationship between China and Japan, staff in the Office were not even allowed to have official contacts with banks with mainland origins, let alone to visit the mainland. Following the normalization of Sino-Japanese relationships in 1972, business trips to the mainland became possible. In addition, the Bank started to send its staff to Hong Kong University to let them study Chinese language. Since then, Hong Kong has played a role as a cradle to foster experts on China at the Bank. In 1978, Hong Kong resumed granting licenses to eligible foreign banks, thereby strengthening its status as an international financial centre. Along with these developments, the importance of the Hong Kong Office to the Bank was firmly established. Hong Kong over the last decade The history of Hong Kong has always been spectacular, but I am convinced the last decade has been the most challenging one. Let me mention just a few particularly significant events. The first is the Asian currency crisis. Since Asia had been praised at that time as a "growth centre," the fact that the crisis occurred in Asia surprised us. It also reminded us of the risk for central banks of drifting into complacency. As you know, this experience led to closer cooperation between the Hong Kong Monetary Authority, the Bank of Japan and other Asian central banks. This co-operation bore fruit in the shape of the Asian Bond Fund, which aims to create a more advanced bond market in Asia, and the swap arrangements called the Chiang Mai initiative which act as a safeguard against any future crisis. When there was mounting selling pressure on the Hong Kong dollar, the Hong Kong Monetary Authority, under the leadership of Chief Executive Yam, adopted various measures to further strengthen the currency board system. The decisive actions remain vivid in my mind. Although Japan's currency system differs from Hong Kong's, we would like to express our respect for the Authority's strong belief in achieving the ultimate goal for a central bank, namely to safeguard the currency system. The second is the SARS epidemic of 2003. It is understandable that some people lost confidence in Hong Kong, as the city faced this appalling epidemic just as the wounds of the Asian currency crisis had begun to heal. However, Hong Kong coped successfully with this epidemic by implementing strict hygiene control measures. In addition, the increased number of visitors from the mainland to Hong Kong, supported by deregulation in the mainland, gave renewed vigor to the tourism industry, severely hit by SARS, thereby strengthening ties between Hong Kong and the mainland. Last but not least, let me highlight once again Hong Kong's current rapid growth, with closer economic ties with the mainland. Hong Kong enjoys solid growth with low inflation, a sound fiscal position and a competitive financial system. Financial markets are booming. Although some were anxious about the possible outcome of handover to China ten years ago, fortunately, this anxiety proved unfounded. Looking ahead Hong Kong seems to make constant efforts toward a more prosperous future, and seems never to be tempted towards complacency. A good example would be the fostering of Renminbi-related financial business through issuances of Renminbi bonds in Hong Kong, while maintaining a currency peg to the U.S. dollar. Hong Kong is blessed with an enviable geographic advantage, being located in the centre of a rapidly-growing Asia. Hong Kong is also rich in the most important production factor for any industry, namely talented human resources like all of you here at this reception. This is, I believe an indispensable strength of Hong Kong. How Hong Kong develops further as an international financial centre is of enormous interest to everyone. Finally, I thank again all our guests for your friendship and co-operation. Recently, everyone in the Asian financial markets is talking about the "unwinding" of the so-called yen carry trades. However, there will definitely be no "unwinding" of the 50-year-long good relationship between Hong Kong and the Bank of Japan. I am fully convinced the co-operation and mutual trust between us will accumulate further. Thank you.
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Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at a meeting with business leaders, Osaka, 5 November 2007.
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Toshihiko Fukui: Bank of Japan’s view on developments in economic activity and its conduct of monetary policy Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at a meeting with business leaders, Osaka, 5 November 2007. * * * Introduction In the year since I last spoke to you here, Japan’s economy has continued to expand moderately, with a virtuous circle of growth in production, income, and spending in place. Although there are uncertainties regarding overseas economies and global financial markets, the economy is likely to continue its moderate but sustained expansion. In the Outlook for Economic Activity and Prices (hereafter the Outlook Report), released at the end of last month, we have provided an outlook that, toward fiscal 2008, our economy will grow, under stable prices, at an average pace of around 2 percent, which is somewhat above its potential growth rate. Today, I would like to explain the Bank of Japan’s view regarding developments in economic activity and prices and the basic thinking behind its conduct of monetary policy. I. The current situation and the outlook for Japan’s economy I would first like to touch upon the current situation of Japan’s economy. Japan’s economy as a whole has continued to expand moderately, although the pace of improvement in the household sector has been somewhat slow relative to the strength in the corporate sector. Exports to the United States have been somewhat weak, but the overall exports have continued to increase steadily as overseas economies taken as a whole have kept growing. In this situation, firms have continued to reinforce their capacity to supply products by increasing fixed capital with a view to capturing profit opportunities in overseas markets. The increase in corporate activity driven by strong exports, coupled with the extremely accommodative financial conditions, has led to growth in business fixed investment among a wider range of industries, including domestic demand-oriented industries. However, since business fixed investment has continued to increase at a rapid pace for the last several years and the level of capital investment is already high, the pace of growth is likely to decelerate gradually. The September Tankan (Short-Term Economic Survey of Enterprises in Japan) indicated that steady growth in business fixed investment would continue, and the pace of increase would slow gradually. It also indicated that corporate profits have been high, and business sentiment has remained generally favorable although some cautiousness was reported in certain sectors. The positive influence of the strength in the corporate sector is feeding through into the household sector slowly but steadily. Wages per worker have been somewhat weak mainly due to the following factors: firms, particularly small ones, have been restraining labor costs in the face of greater exposure to global competition and capital market discipline, and increased materials prices; and with the high-salaried baby-boomer generation retiring, an increasing number of relatively low-salaried workers, such as new graduates and part-time workers, have been recruited. Meanwhile, the number of employees has been increasing at a year-on-year rate of around 1 percent, and employee income has continued rising moderately. At the same time, strength in the corporate sector has been filtering through into the household sector via various channels, for example, increased dividends. While spending on clothes and other daily necessities has been somewhat weak, growth in spending in areas where firms have increasingly been providing new products and services designed to meet consumer needs has been high as evidenced by, for example, strong sales of digital appliances. Spending behavior has thus varied with the type of goods and services, but private consumption, taken as a whole, has remained firm. In sum, our economy is currently experiencing moderate expansion. The virtuous circle of growth in production, income, and spending is likely to remain intact against the background of the expansion of the global market and the extremely accommodative financial conditions, although there are uncertainties regarding overseas economies and global financial markets. In this situation, upward pressures on prices are likely to build up gradually. Looking at recent developments in price indices, while the domestic corporate goods price index (CGPI) has been rising mainly due to increases in international commodity prices, higher materials prices have not been passed through to the retail level as much as at the wholesale level. This seems to indicate that with intensifying competition among firms due partly to globalization and deregulation, many firms are restraining increases in prices through improvements in productivity and various cost reduction measures. In this situation, the year-on-year rate of change in the consumer price index (CPI, excluding fresh food) has remained at around 0 percent. However, if the economy continues to grow at a rate exceeding its potential, resource utilization, namely in labor and production capacity, will increase further. In such a situation, it is expected that supply and demand conditions for consumer goods and services will further tighten and that this will exert upward pressure on consumer prices as more firms pass on higher costs to consumers. Moreover, unit labor costs (labor costs per unit of output), although currently still declining, are likely to stop falling as wages begin to show a gradual upward trend. With these understandings, the year-on-year rate of change in the CPI (excluding fresh food) is likely to be around 0 percent in the short run, but is expected gradually to rise in the longer run. However, the pace of increase is likely to be moderate, given that the sensitivity of prices to changes in the output gap is declining due to factors such as economic globalization and deregulation. The rate of increase is projected to be around 0 percent in fiscal 2007 and around 0.5 percent in fiscal 2008. II. Developments in overseas economies I have so far outlined the most likely projection. However, any kind of projection is subject to upside and downside risks. The first risk concerns developments in overseas economies. The global economy has been expanding strongly, registering high growth of around 5 percent since 2004. It is the first time since the early 1970s that the global economy has registered such high growth over a period of this length: until 2003, the growth rate was around 3 to 4 percent. The high growth of the global economy is to a great extent attributable to the fact that emerging economies have taken off one after another and have been increasing their presence in the global economy. In the U.S. economy, the correction in the housing market is continuing, but business fixed investment and private consumption continue to be on a moderate increasing trend although the pace of increase is decelerating. If the housing correction does not spread to other areas of the economy and the economic slowdown is only moderate, the global economy is likely to continue to expand steadily with the slowing of U.S. economic growth being offset by high growth in emerging economies such as the BRICs. This was also the consensus view among delegates at the G-7 and International Monetary Fund meetings in October. As you all know, global financial markets have been volatile since the summer due to the heightening of concern about the U.S. subprime mortgage problem. This recent volatility in global financial markets could be regarded as laxity in risk evaluation in the continued benign global economic and financial environment being reversed by market forces of selfcorrection. However, if the correction in the U.S. housing market intensifies or the effects of swings in financial markets become unexpectedly widespread, private consumption and business fixed investment may become weaker than expected due to the negative wealth effect, credit tightening, and deterioration in business and consumer sentiment, thereby leading to further deceleration in U.S. economic growth. Although the European economy is likely to expand steadily, growth may slow depending on the effect of volatile global financial markets on financial conditions. If these risks related to the U.S. and European economies were to materialize, this may, depending on the extent, affect growth of other economies such as emerging economies, and this could cause global economic growth to be weaker than expected. In view of the high rate of growth that the global economy has maintained, attention should also be paid to inflationary pressures. In the United States, inflationary pressures may not subside as a result of higher resource utilization, namely in labor and production capacity, coupled with developments in crude oil prices. The Chinese economy continues to grow strongly, but there are signs of overheating, particularly in fixed asset investment, indicating that economic activity and prices may deviate upward from the expected path. Because of the strong growth of the global economy and geopolitical risks, international commodity prices such as crude oil prices remain elevated, and they may affect the global economy and the price situation depending on future developments in these prices. Thus, there is a risk that disruptive changes in overseas economies or global financial markets may affect Japan’s economy through changes in exports and imports, corporate profits, and financial market conditions such as foreign exchange rates and long-term interest rates. III. Swings in financial and economic activity The second risk concerns possible larger swings in financial and economic activity as a result of a misallocation of resources under continuing accommodative financial conditions. Some argue that recent developments in yen carry trades are a sign of such a potential risk. In Japan, there have so far been only limited effects on financial conditions stemming from the U.S. subprime mortgage problem and the subsequent volatility in overseas financial markets, and the lending attitude of financial institutions has remained positive. The issuing environment for CP and corporate bonds has been favorable. Japan’s current economic circumstances, with the financial positions of both firms and financial institutions improving and real interest rates remaining very low, are such as potentially to encourage assertive financial and economic activity. According to the Prefectural Land Price Survey released in September, the rate of increase in land prices in the three major metropolitan areas (Tokyo, Osaka, and Nagoya) has accelerated against the background of increases in redevelopment projects and steady demand for office space. These developments may also cause activity of both firms and financial institutions to accelerate. If greater assertiveness should be based on optimistic assumptions regarding future sales and profits, financing costs, foreign exchange rates, and asset prices, the result could well be a misallocation of resources in the long run as agents become over-extended in financial markets or pour funds and other resources into inefficient economic activities. Such developments may push up economic growth in the short run, but lead to later downward adjustments and hamper the sustainability of economic growth. IV. Sensitivity of prices to changes in the output gap These upside and downside risks to the outlook for economic activity may affect prices should they materialize, but there are also upside and downside risks unique to price developments that could cause prices to deviate from the projection. The sensitivity of prices to changes in the output gap has been declining in recent years. This tendency has been taken into account in our projection for prices mentioned earlier, but the degree of decline is uncertain and the sensitivity of prices may turn out to be lower than assumed in the projection. If factors strongly restraining wage growth remain despite prolonged economic expansion, downward pressure on prices from labor costs would persist. Moreover, if the positive influence of the strength in the corporate sector feeds through into the household sector more slowly than expected due to sluggish wage growth, supply and demand conditions for consumer goods and services may not improve as much as the output gap suggests. In such a situation, prices may not be responsive to the improvement in the economic situation. On the other hand, if the economy continues to grow at a pace exceeding its potential through fiscal 2008, it is likely that the utilization of resources such as labor and production capacity will rise further and the output gap will show further tightening of supply and demand conditions. Inflation expectations, which have been low and stable, may rise with higher resource utilization, particularly in labor, along with increased prices of crude oil and other international commodities. Moreover, although firms are likely to continue to restrain labor costs, they may change their attitude with the aim of hiring or retaining skilled workers. These potential changes would exert upward pressure on prices. V. Conduct of monetary policy Next, I would like to elaborate on the future conduct of monetary policy, keeping in mind the projection for economic activity and prices and the possibility that they may deviate from the projection. The Bank assesses the economic and price situation from two perspectives and then outlines its thinking on the future conduct of monetary policy, taking account of the "understanding of medium- to long-term price stability" (in numerical terms, a range approximately between 0 and 2 percent in the year-on-year rate of change in the CPI), which is the level of inflation that each member of the Policy Board understands, when conducting monetary policy, as being consistent with price stability over the medium to long term. To further your understanding of the two perspectives, I would like to assess the developments in economic activity and prices that I have explained based on these two perspectives. The first perspective involves assessing whether the most likely outlook for economic activity and prices will remain on the path of sustainable growth under price stability. As I said earlier, it is likely that Japan’s economy will continue its sustained expansion with a virtuous circle of growth in production, income, and spending in place, and this is the Bank’s baseline scenario. The year-on-year rate of change in the CPI (excluding fresh food) is likely to be around 0 percent in the short run, but is expected gradually to rise in the longer run. In sum, under the first perspective, we are of the view that, through fiscal 2008, Japan’s economy is likely to realize sustainable growth under price stability. The second perspective extends the time horizon and assesses the risks, taking account of the cost incurred should they materialize, even though the probability of this happening may be low. Since I have already referred to these risks as possible upward and downward deviations of the economy and prices, let me review these risks briefly. There are uncertainties regarding overseas economies and global financial markets and if their situation changes significantly, Japan’s economy will inevitably be affected. There is also a possibility that prices will continue not to rise despite the improvement in economic conditions. Lastly, attention should continue to be paid to the risk that the stimulative effect of monetary policy may be further amplified with the improved prospects for economic activity and prices. If, for instance, the expectation takes hold that interest rates will remain low for a long time regardless of developments in economic activity and prices, this may result in medium- to long-term risks of larger swings in the economy and inflation rate through misallocation of funds and resources. I would now like to talk about the Bank’s conduct of monetary policy, bearing in mind the assessment above. The Bank’s basic thinking has been that (1) given the extremely accommodative financial conditions, the level of interest rates is to be raised if Japan’s economy is to follow a path of sustainable growth under price stability, and (2) the pace of increase in interest rates should be determined in accordance with improvements in the economic and price situation without any predetermined view. So far, weak inflationary pressures have given the Bank latitude in conducting monetary policy. The actual interest rate adjustments have therefore been slow based on a thorough assessment of the future path of the economy and prices and its likelihood, as well as both upside and downside risks. The Bank’s basic thinking in this regard will remain the same in the conduct of future monetary policy. That is, while confirming that the Japanese economy remains likely to follow a path of sustainable growth under price stability and assessing relevant upside and downside risk factors, the Bank will adjust the level of interest rates gradually in accordance with improvements in the economic and price situation. We believe that, from the long-term perspective, the conduct of monetary policy in such a manner will prevent the risk of larger swings in economic activity and prices from materializing and will help to realize sustainable growth under price stability. Conclusion Japan’s economy is expanding moderately. Corporate activity has been increasing due partly to strong exports, as can be seen here in the Kansai region, and the positive influence is clearly spreading throughout the wider economy as evident in the declining unemployment rate. In order for Japan’s economy to continue sustainable growth in the face of various challenges including the declining population, it is crucial for all regions and industries to persist with their efforts to innovate. Since, along with the Kanto and Tokai regions, the Kansai region is pulling Japan’s economy forward, I fully anticipate that your originality and inventiveness will continue to play a leading role. As for the Bank, we will continue to support your efforts through our conduct of monetary policy.
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Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at a meeting with business leaders, Osaka, 5 November 2007.
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Toshihiko Fukui: Developments in economic activity and prices in Japan and the conduct of monetary policy Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at a meeting with business leaders, Osaka, 5 November 2007. * * * Introduction In the year since I last spoke to you here, Japan's economy has continued to expand moderately, with a virtuous circle of growth in production, income, and spending in place. Although there are uncertainties regarding overseas economies and global financial markets, the economy is likely to continue its moderate but sustained expansion. In the Outlook for Economic Activity and Prices (hereafter the Outlook Report), released at the end of last month, we have provided an outlook that, toward fiscal 2008, our economy will grow, under stable prices, at an average pace of around 2 percent, which is somewhat above its potential growth rate. Today, I would like to explain the Bank of Japan's view regarding developments in economic activity and prices and the basic thinking behind its conduct of monetary policy. I. The current situation and the outlook for Japan's economy I would first like to touch upon the current situation of Japan's economy. Japan's economy as a whole has continued to expand moderately, although the pace of improvement in the household sector has been somewhat slow relative to the strength in the corporate sector. Exports to the United States have been somewhat weak, but the overall exports have continued to increase steadily as overseas economies taken as a whole have kept growing. In this situation, firms have continued to reinforce their capacity to supply products by increasing fixed capital with a view to capturing profit opportunities in overseas markets. The increase in corporate activity driven by strong exports, coupled with the extremely accommodative financial conditions, has led to growth in business fixed investment among a wider range of industries, including domestic demand-oriented industries. However, since business fixed investment has continued to increase at a rapid pace for the last several years and the level of capital investment is already high, the pace of growth is likely to decelerate gradually. The September Tankan (Short-Term Economic Survey of Enterprises in Japan) indicated that steady growth in business fixed investment would continue, and the pace of increase would slow gradually. It also indicated that corporate profits have been high, and business sentiment has remained generally favorable although some cautiousness was reported in certain sectors. The positive influence of the strength in the corporate sector is feeding through into the household sector slowly but steadily. Wages per worker have been somewhat weak mainly due to the following factors: firms, particularly small ones, have been restraining labor costs in the face of greater exposure to global competition and capital market discipline, and increased materials prices; and with the high-salaried baby-boomer generation retiring, an increasing number of relatively low-salaried workers, such as new graduates and part-time workers, have been recruited. Meanwhile, the number of employees has been increasing at a year-on-year rate of around 1 percent, and employee income has continued rising moderately. At the same time, strength in the corporate sector has been filtering through into the household sector via various channels, for example, increased dividends. While spending on clothes and other daily necessities has been somewhat weak, growth in spending in areas where firms have increasingly been providing new products and services designed to meet consumer needs has been high as evidenced by, for example, strong sales of digital appliances. Spending behavior has thus varied with the type of goods and services, but private consumption, taken as a whole, has remained firm. In sum, our economy is currently experiencing moderate expansion. The virtuous circle of growth in production, income, and spending is likely to remain intact against the background of the expansion of the global market and the extremely accommodative financial conditions, although there are uncertainties regarding overseas economies and global financial markets. In this situation, upward pressures on prices are likely to build up gradually. Looking at recent developments in price indices, while the domestic corporate goods price index (CGPI) has been rising mainly due to increases in international commodity prices, higher materials prices have not been passed through to the retail level as much as at the wholesale level. This seems to indicate that with intensifying competition among firms due partly to globalization and deregulation, many firms are restraining increases in prices through improvements in productivity and various cost reduction measures. In this situation, the year-on-year rate of change in the consumer price index (CPI, excluding fresh food) has remained at around 0 percent. However, if the economy continues to grow at a rate exceeding its potential, resource utilization, namely in labor and production capacity, will increase further. In such a situation, it is expected that supply and demand conditions for consumer goods and services will further tighten and that this will exert upward pressure on consumer prices as more firms pass on higher costs to consumers. Moreover, unit labor costs (labor costs per unit of output), although currently still declining, are likely to stop falling as wages begin to show a gradual upward trend. With these understandings, the year-on-year rate of change in the CPI (excluding fresh food) is likely to be around 0 percent in the short run, but is expected gradually to rise in the longer run. However, the pace of increase is likely to be moderate, given that the sensitivity of prices to changes in the output gap is declining due to factors such as economic globalization and deregulation. The rate of increase is projected to be around 0 percent in fiscal 2007 and around 0.5 percent in fiscal 2008. II. Developments in overseas economies I have so far outlined the most likely projection. However, any kind of projection is subject to upside and downside risks. The first risk concerns developments in overseas economies. The global economy has been expanding strongly, registering high growth of around 5 percent since 2004. It is the first time since the early 1970s that the global economy has registered such high growth over a period of this length: until 2003, the growth rate was around 3 to 4 percent. The high growth of the global economy is to a great extent attributable to the fact that emerging economies have taken off one after another and have been increasing their presence in the global economy. In the U.S. economy, the correction in the housing market is continuing, but business fixed investment and private consumption continue to be on a moderate increasing trend although the pace of increase is decelerating. If the housing correction does not spread to other areas of the economy and the economic slowdown is only moderate, the global economy is likely to continue to expand steadily with the slowing of U.S. economic growth being offset by high growth in emerging economies such as the BRICs. This was also the consensus view among delegates at the G-7 and International Monetary Fund meetings in October. As you all know, global financial markets have been volatile since the summer due to the heightening of concern about the U.S. subprime mortgage problem. This recent volatility in global financial markets could be regarded as laxity in risk evaluation in the continued benign global economic and financial environment being reversed by market forces of selfcorrection. However, if the correction in the U.S. housing market intensifies or the effects of swings in financial markets become unexpectedly widespread, private consumption and business fixed investment may become weaker than expected due to the negative wealth effect, credit tightening, and deterioration in business and consumer sentiment, thereby leading to further deceleration in U.S. economic growth. Although the European economy is likely to expand steadily, growth may slow depending on the effect of volatile global financial markets on financial conditions. If these risks related to the U.S. and European economies were to materialize, this may, depending on the extent, affect growth of other economies such as emerging economies, and this could cause global economic growth to be weaker than expected. In view of the high rate of growth that the global economy has maintained, attention should also be paid to inflationary pressures. In the United States, inflationary pressures may not subside as a result of higher resource utilization, namely in labor and production capacity, coupled with developments in crude oil prices. The Chinese economy continues to grow strongly, but there are signs of overheating, particularly in fixed asset investment, indicating that economic activity and prices may deviate upward from the expected path. Because of the strong growth of the global economy and geopolitical risks, international commodity prices such as crude oil prices remain elevated, and they may affect the global economy and the price situation depending on future developments in these prices. Thus, there is a risk that disruptive changes in overseas economies or global financial markets may affect Japan's economy through changes in exports and imports, corporate profits, and financial market conditions such as foreign exchange rates and long-term interest rates. III. Swings in financial and economic activity The second risk concerns possible larger swings in financial and economic activity as a result of a misallocation of resources under continuing accommodative financial conditions. Some argue that recent developments in yen carry trades are a sign of such a potential risk. In Japan, there have so far been only limited effects on financial conditions stemming from the U.S. subprime mortgage problem and the subsequent volatility in overseas financial markets, and the lending attitude of financial institutions has remained positive. The issuing environment for CP and corporate bonds has been favorable. Japan's current economic circumstances, with the financial positions of both firms and financial institutions improving and real interest rates remaining very low, are such as potentially to encourage assertive financial and economic activity. According to the Prefectural Land Price Survey released in September, the rate of increase in land prices in the three major metropolitan areas (Tokyo, Osaka, and Nagoya) has accelerated against the background of increases in redevelopment projects and steady demand for office space. These developments may also cause activity of both firms and financial institutions to accelerate. If greater assertiveness should be based on optimistic assumptions regarding future sales and profits, financing costs, foreign exchange rates, and asset prices, the result could well be a misallocation of resources in the long run as agents become over-extended in financial markets or pour funds and other resources into inefficient economic activities. Such developments may push up economic growth in the short run, but lead to later downward adjustments and hamper the sustainability of economic growth. IV. Sensitivity of prices to changes in the output gap These upside and downside risks to the outlook for economic activity may affect prices should they materialize, but there are also upside and downside risks unique to price developments that could cause prices to deviate from the projection. The sensitivity of prices to changes in the output gap has been declining in recent years. This tendency has been taken into account in our projection for prices mentioned earlier, but the degree of decline is uncertain and the sensitivity of prices may turn out to be lower than assumed in the projection. If factors strongly restraining wage growth remain despite prolonged economic expansion, downward pressure on prices from labor costs would persist. Moreover, if the positive influence of the strength in the corporate sector feeds through into the household sector more slowly than expected due to sluggish wage growth, supply and demand conditions for consumer goods and services may not improve as much as the output gap suggests. In such a situation, prices may not be responsive to the improvement in the economic situation. On the other hand, if the economy continues to grow at a pace exceeding its potential through fiscal 2008, it is likely that the utilization of resources such as labor and production capacity will rise further and the output gap will show further tightening of supply and demand conditions. Inflation expectations, which have been low and stable, may rise with higher resource utilization, particularly in labor, along with increased prices of crude oil and other international commodities. Moreover, although firms are likely to continue to restrain labor costs, they may change their attitude with the aim of hiring or retaining skilled workers. These potential changes would exert upward pressure on prices. V. Conduct of monetary policy Next, I would like to elaborate on the future conduct of monetary policy, keeping in mind the projection for economic activity and prices and the possibility that they may deviate from the projection. The Bank assesses the economic and price situation from two perspectives and then outlines its thinking on the future conduct of monetary policy, taking account of the "understanding of medium- to long-term price stability" (in numerical terms, a range approximately between 0 and 2 percent in the year-on-year rate of change in the CPI), which is the level of inflation that each member of the Policy Board understands, when conducting monetary policy, as being consistent with price stability over the medium to long term. To further your understanding of the two perspectives, I would like to assess the developments in economic activity and prices that I have explained based on these two perspectives. The first perspective involves assessing whether the most likely outlook for economic activity and prices will remain on the path of sustainable growth under price stability. As I said earlier, it is likely that Japan's economy will continue its sustained expansion with a virtuous circle of growth in production, income, and spending in place, and this is the Bank's baseline scenario. The year-on-year rate of change in the CPI (excluding fresh food) is likely to be around 0 percent in the short run, but is expected gradually to rise in the longer run. In sum, under the first perspective, we are of the view that, through fiscal 2008, Japan's economy is likely to realize sustainable growth under price stability. The second perspective extends the time horizon and assesses the risks, taking account of the cost incurred should they materialize, even though the probability of this happening may be low. Since I have already referred to these risks as possible upward and downward deviations of the economy and prices, let me review these risks briefly. There are uncertainties regarding overseas economies and global financial markets and if their situation changes significantly, Japan's economy will inevitably be affected. There is also a possibility that prices will continue not to rise despite the improvement in economic conditions. Lastly, attention should continue to be paid to the risk that the stimulative effect of monetary policy may be further amplified with the improved prospects for economic activity and prices. If, for instance, the expectation takes hold that interest rates will remain low for a long time regardless of developments in economic activity and prices, this may result in medium- to long-term risks of larger swings in the economy and inflation rate through misallocation of funds and resources. I would now like to talk about the Bank's conduct of monetary policy, bearing in mind the assessment above. The Bank's basic thinking has been that (1) given the extremely accommodative financial conditions, the level of interest rates is to be raised if Japan's economy is to follow a path of sustainable growth under price stability, and (2) the pace of increase in interest rates should be determined in accordance with improvements in the economic and price situation without any predetermined view. So far, weak inflationary pressures have given the Bank latitude in conducting monetary policy. The actual interest rate adjustments have therefore been slow based on a thorough assessment of the future path of the economy and prices and its likelihood, as well as both upside and downside risks. The Bank's basic thinking in this regard will remain the same in the conduct of future monetary policy. That is, while confirming that the Japanese economy remains likely to follow a path of sustainable growth under price stability and assessing relevant upside and downside risk factors, the Bank will adjust the level of interest rates gradually in accordance with improvements in the economic and price situation. We believe that, from the long-term perspective, the conduct of monetary policy in such a manner will prevent the risk of larger swings in economic activity and prices from materializing and will help to realize sustainable growth under price stability. Conclusion Japan's economy is expanding moderately. Corporate activity has been increasing due partly to strong exports, as can be seen here in the Kansai region, and the positive influence is clearly spreading throughout the wider economy as evident in the declining unemployment rate. In order for Japan's economy to continue sustainable growth in the face of various challenges including the declining population, it is crucial for all regions and industries to persist with their efforts to innovate. Since, along with the Kanto and Tokai regions, the Kansai region is pulling Japan's economy forward, I fully anticipate that your originality and inventiveness will continue to play a leading role. As for the Bank, we will continue to support your efforts through our conduct of monetary policy.
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Speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at MAS Lecture 2007, Monetary Authority of Singapore, Singapore, 15 November 2007.
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Toshihiko Fukui: Central banking under globalization Speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at MAS Lecture 2007, Monetary Authority of Singapore, Singapore, 15 November 2007. * * * I am very privileged to have been invited by the Monetary Authority of Singapore to deliver its 2007 lecture. I have seen the list of prominent speakers in past lectures, and I am much honored to follow them. My topic today is the role of central banks in the context of increasing economic globalization. I. Progress in economic globalization As globalization proceeds, cross-border trading of goods and services as well as funds and financial products has been increasing. Although this trend had been underway for at least half a century, the pace of increase seems to have accelerated in recent years. According to research done by the International Monetary Fund (IMF), world real GDP increased by around 50 percent over the last decade (from 1996 to 2006), indicating a high growth rate. Over the same period, the volume of world trade almost doubled, representing a growth rate around 30 percent faster than that of world GDP. This means that international trade in goods and services has outperformed the expansion in the world economy. Also, from 1994 to 2004, the growth in the global sum of overseas assets and liabilities outpaced that of world GDP by around 50 percent, and this can be considered an indication of the progress in financial globalization. The rapid pace of globalization is closely related to advances in information and communications technology (ICT) and strong growth in Asia and other emerging economies. The progress in ICT has further eased geographical limitations on cross-border transactions of goods, services, and financial products. Against the background of these technological innovations, emerging economies, with their abundant supply of skilled labor, have established their position as global production bases. In addition, emerging economies are now regarded not only as production sites for manufacturers but also as locations for software development centers or call centers for non-manufacturers. These economies are now being brought into the business process of supply-chain management by many firms. With the accumulation of purchasing power through this process, emerging economies have also increased their presence as markets with huge potential. In the meantime, their wealth, coupled with abundant funds accumulated in oil-producing countries, has caused a significant increase in the international flow of funds. This has in turn promoted financial innovation such as the introduction of sophisticated financial products and the expansion of financial players such as managed funds. Development of the international division of labor and progress in financial innovation have fostered efficient allocation of resources, thereby contributing to world growth. World GDP growth is likely to register around 5 percent this year, close to what we have been observing since 2003. Another feature of current world economic growth is a reduction in the amplitude of fluctuations in the rate of growth and inflation. This is the so-called "Great Moderation," often cited by academics and economists. The stability in the world economy and prices became noticeable after the Second Oil Crisis. The inflation rate, in particular, has decreased substantially since the year 2000 in terms of its average in both industrialized countries and emerging economies, and has also been less volatile. The current situation of the world economy, where low inflation coexists with high economic growth, seems favorable for central banks, which aim to achieve stability in prices and in economic activity. However, it is a regrettable truth that the job of central banks never gets easier, only more challenging. Let me now discuss some phenomena that have brought new challenges into being. II. Changes in the relationship between output and prices The first phenomenon is that the conventional wisdom regarding the relationship between output and prices is becoming increasingly inapplicable. In technical economic terms, this phenomenon could be described as a "flattening of the Phillips curve," and there is uncertainty about how flat the curve has actually become, how long this situation will continue, and whether the relationship will eventually return to its previous state. This phenomenon has been observed in many industrialized countries, and I would like to outline the situation in Japan as an example. After hitting bottom in 2002, the Japanese economy entered the phase of recovery, supported by strong external demand due to the expansion of overseas economies. In recent years, the annual growth rate has been around 2 percent, slightly higher than the economy's potential growth rate, and resource utilization, namely in labor and production capacity, has been increasing. However, upward pressure on prices has yet to rise markedly. The year-onyear rate of change in the consumer price index (CPI, excluding fresh food) was negative from fiscal 1998 through fiscal 2004, and has since been around 0 percent. I think this situation, where prices do not rise despite the steady growth of the economy, is in part due to changes in the environment surrounding prices and wages amid the progress of globalization. Products made in Japan have been facing fierce competition from products imported from emerging economies. In the meantime, Japanese workers have been experiencing increased competition from their counterparts in emerging economies through growth in imports and direct investment. In the face of greater exposure to global competition and capital market discipline, Japanese firms have continued to restrain labor costs to increase corporate value, even under tighter labor market conditions. Meanwhile, employees in most cases still prefer stable employment over wage increases because of their past experience of a severe employment situation. To put it simply, prices are becoming more susceptible to global factors, while the sensitivity of prices to the state of the domestic economy has been declining. With these changes in the environment surrounding prices, the conduct of monetary policy has become increasingly difficult. In general, interest rate policy affects economic activity first and then influences prices through changes in resource utilization. As the relationship between output and prices has changed and the conventional wisdom no longer applies, it is becoming more difficult for central banks to envisage how much change in the interest rate will be needed to bring about a desired change in the inflation rate. Since March last year, when the Bank of Japan terminated the quantitative easing policy and reinstated an interest rate regime, we have raised the policy rate at a moderate pace, even though the year-on-year rate of change in the CPI has remained stable at around 0 percent. A factor behind this conduct of monetary policy is the changes in the relationship between economic activity and prices I have just discussed. With these changes, the pace of growth in Japan's economy needed to raise the inflation rate in a short period of time would have to be quite high. In addition, significant uncertainty remains as to the exact rate of growth that would be desirable. Monetary policy aimed at such a high level of growth in the economy could bring about larger swings in the economy and risk the sustainability of the economic expansion. The alternative, safer and more prudent route is to focus on securing sustained economic growth and minimizing swings, generating a gradual rise in the inflation rate. In the NIEs and ASEAN economies, reductions in both the rate of inflation and its amplitude of fluctuations have also been observed. Given the relative openness of their economies and their geographical proximity to the fast-growing Chinese economy, the NIEs and ASEAN economies seem to have been significantly influenced by ongoing globalization. Of course, the attainment of price stability is a major achievement of monetary policy conducted by central banks in these economies with their main focus on prices since the Asian currency crises, and this has greatly contributed to the growth and stability of the global economy. If I may add, prices of international commodities such as crude oil have recently risen substantially despite the stability in prices on a global basis. This will inevitably impair terms of trade for oil-consuming countries, but what is important, in terms of the price situation, is its influence on inflation expectations. There is a risk of a rise in inflation expectations in the longer term under tight demand and supply conditions given that recent rises in commodity prices are due in part to continued high growth in the world economy, especially in emerging economies. This implies that the Phillips curve may shift upward. Although inflation expectations so far seem generally contained in many countries, appropriate monetary policy designed to achieve price stability and sustained economic growth is becoming increasingly important. III. The conduct of monetary policy from a medium- to long-term perspective Next, I would like to take up the recent disruptions in global financial markets stemming from the subprime mortgage problem in the United States. Although recent events could be considered from various points of view, I think they were intimately related to the benign conditions of the world economy and financial markets that continued for many years under economic globalization, as I have just described. The crux of the problem, as I understand it, is that risk evaluation had become too lax under those benign conditions and this has led to a correction through market forces. If we look back historically, we can see many cases where excessive financial and economic activities continued for a certain period based on optimistic profit assumptions, and eventually resulted in large fluctuations in economic activity and prices or in financial crises through a later reaction. The Great Depression of the 1930s, Japan's asset price bubble in the 1980s, the Asian currency crisis in the late 1990s, and the IT bubble of the early 2000s are examples. The common feature shared by all of these was that imbalances in the economy and prices had grown under seemingly favorable and stable conditions in the economy and prices. If expectations take hold that a low interest rate environment will continue indefinitely, the rate for discounting expected future returns in the determination of asset prices will be likely to decline, bringing about a rise in asset prices. A similar situation could also come about as a result of optimistic assumptions about profits when an economy has enjoyed continuous high growth for a considerable time. For example, there was the rise of influential concepts such as "transformation to domestically led economic growth" in Japan during the 1980s and the "Asian miracle" in the 1990s prior to the Asian currency crisis. These concepts led economic agents to lower their awareness of risks and to overestimate their future profitability. Given these dangers, it has become more important for us to respond to risks that may bring about larger swings in economic activity and prices in the longer run, since central banks have a mission to conduct monetary policy to achieve price stability in the medium to long term. To be more specific, it is essential to carry out careful assessment of risks that may be relatively unlikely to materialize but, if they did, would have a large impact on the economy and prices, such as an asset price bubble. It is also essential to assess financial conditions and inflation expectations that may influence the economy and prices in the medium to long term. I think such awareness is shared by most central banks, but policy frameworks differ on how to incorporate this in the actual conduct of monetary policy. In the case of the Bank of Japan, the current monetary policy framework was introduced when the quantitative easing policy framework was terminated last year. Under the new framework, (1) we examine the most likely outlook for economic activity and prices for one to two years ahead, and (2) we assess risks considered most relevant to the conduct of monetary policy from a longer-term perspective. The recent disruptions in global financial markets seem to show that under the continuing favorable conditions of healthy world growth and low inflation, financial imbalances can accumulate, which will be followed by corrections, posing a risk to economic stability. In more general terms, recent events could be regarded as a reminder of the importance of progress in which financial and economic activities remain in harmony. Recent events have strengthened my belief that it is important for a central bank to assess various factors that may have negative consequences for the situation of the economy and prices in the medium to long term. IV. Market stabilization and central bank activities Central banks can also learn a lesson from the recent market disruptions from a rather different standpoint. It is a central bank's role to stabilize the market when it is under pressure. The recent market disruptions occurred when there were growing uncertainties about the location of risks due to the complexity of the international flow of funds under economic globalization. Risks have been dispersed and re-accumulated in various markets through the medium of advanced financial products whose risks are not easy to evaluate. At the same time, given the wide range of financial players, including hedge funds and private equity funds, the identity of risk-taking parties and the scale of risks have become blurred, masking the nature of the risks the financial system is exposed to. The problem stemming from the rise in housing mortgage loan delinquencies has crossed the Atlantic to the European markets through a decline in the credit ratings of securitized products such as asset-backed commercial paper (ABCP) with mortgage loans as collateral. With uncertainty regarding the location and the scale of risks, the functioning of credit markets including securitized markets has deteriorated overall. Conditions in money markets in the United States and European countries turned volatile because of increased counterparty risks among financial institutions, and central banks have aggressively supplied funds to these markets. The Japanese money market, however, has been generally calm, with our policy interest rate, the overnight call rate, remaining close to our target level. The most significant factor that kept the Japanese money market stable was the limited exposure of Japanese financial institutions to subprime mortgage-related products. The stability could also be attributed to the ability of the Bank to accurately grasp financial market situations and perform money market operations, developed through a variety of past experiences including financial crisis. To be more specific, the following seem to have contributed: (1) an accurate grasp of the money market conditions through daily monitoring of transactions by market participants; disclosure of information concerning money market operations through, for example, daily release of shortage and surplus of funds in the money market, both projections and actual results; and (3) flexible use of money market operation tools covering maturities from overnight to three months, depending on market conditions. These are part of our normal modalities of money market operations and nothing special. It is necessary for a central bank to accurately grasp the daily liquidity needs of market participants as well as overall market conditions because monetary policy works through influencing money market conditions and the behavior of market participants. In addition, understanding each financial institution's soundness, thereby contributing to the soundness of the financial system, is an important element of central banking. The ability to closely monitor the liquidity condition of financial institutions should be finely honed in normal times. After all, a central bank is a "bank." Recent actions by central banks to calm market turbulence seem to have highlighted the simple fact that it is through its banking business that a central bank plays a principal role. Faced with increasing complexity in the international flow of funds, which may bring about sudden stress in the working of financial markets, it is becoming ever more important for a central bank to accumulate further knowledge about financial conditions through its daily activities. V. Concluding remarks I sometimes describe central banking in terms of the role of the goalkeeper in a football team. It is rare for goalkeepers to score a goal themselves, but what they do is support their teammates in their efforts to score by defending their goal from the enemy's attacks. In defense, it is vital to read the enemy's offensive strategy; in the conduct of monetary policy, it is essential to accurately assess the risk profiles of economic activity and financial market conditions. When on the offensive, good teamwork is important; in monetary policy terms, it is important to facilitate the efficient allocation of resources and stimulate innovation. The dynamic progress of economic globalization brings with it challenges for central banks such as I have discussed today, but we intend to grapple with them and bring victory to the team by supporting players in the globalized economy. Thank you.
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Statement by Mr Toshihiko Fukui, Governor of the Bank of Japan, concerning the Bank's Semiannual Report on Currency and Monetary Control, before the Committee on Financial Affairs, House of Councillors and House of Representatives, 1-2 November 2007.
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Toshihiko Fukui: Developments in Japan’s economy and an overall review of the central bank’s conduct of monetary policy Statement by Mr Toshihiko Fukui, Governor of the Bank of Japan, concerning the Bank's Semiannual Report on Currency and Monetary Control, before the Committee on Financial Affairs, House of Councillors and House of Representatives, 1-2 November 2007. * * * Introduction The Bank of Japan submitted its Semiannual Report on Currency and Monetary Control for the second half of fiscal 2006 to the Diet on June 8, 2007. I am pleased to have this opportunity to present an overall review of the Bank's conduct of monetary policy. I. Developments in Japan's economy Japan's economy is expanding moderately. Exports have continued to increase due to the expansion of overseas economies. Business fixed investment has also continued to trend upward against the background of high corporate profits. The positive effects of the strength in the corporate sector have been feeding through moderately into the household sector. Although nominal wages per worker have been somewhat weak, employee income has been rising moderately with the increase in the number of employees. The positive effects of the strength in the corporate sector have also continued to be passed on via various other channels, for example, increased dividends. In this situation private consumption has been firm. With the rise in demand both at home and abroad, production has continued to be on an increasing trend. Looking forward, Japan's economy is likely to continue its sustained expansion with a virtuous circle of growth in production, income, and spending in place. However, instability in global financial markets stemming from the U.S. subprime mortgage problem continues, and there is uncertainty regarding global economic developments, for example downside risks to the U.S. economy. Although overseas economies, taken as a whole, are likely to keep expanding as growth in economies other than the United States is likely to remain high, developments in global financial markets and the global economy continue to warrant attention. On the price front, the three-month rate of change in domestic corporate goods prices has been positive, mainly due to the rise in international commodity prices. The year-on-year rate of change in the consumer price index (excluding fresh food) has been around 0 percent. From a longer-term perspective, however, it is projected to continue to follow a positive trend as the output gap continues to be positive. As for financial conditions, the environment for corporate finance has been accommodative. In the CP and corporate bond markets, the issuing environment has been favorable. The lending attitudes of private banks have continued to be accommodative. Under these circumstances, the amount outstanding of lending by private banks has been increasing moderately, and the amount outstanding of CP and corporate bonds issued has been above the previous year's level. II. Conduct of monetary policy Regarding the conduct of monetary policy, the Bank's basic thinking has been that (1) given the extremely accommodative financial conditions, the level of interest rates is to be raised if Japan's economy is to follow a path of sustainable growth under price stability, and (2) the pace of increase in interest rates should be determined in accordance with improvements in the economic and price situation without any predetermined view. Weak inflationary pressures have given the Bank latitude in conducting monetary policy. The actual interest rate adjustments have therefore been slow based on a thorough assessment of the future path of the economy and prices and its likelihood, as well as both upside and downside risks. The Bank's basic thinking in this regard will remain the same in the conduct of future monetary policy. In other words, while confirming that Japan's economy remains likely to follow a path of sustainable growth under price stability and assessing relevant upside and downside risk factors, the Bank will adjust the level of interest rates gradually in accordance with improvements in the economic and price situation. The Bank is determined to conduct monetary policy appropriately based on careful assessment of economic activity and prices as well as the situation of financial markets at home and abroad, thereby contributing to sustainable economic growth under price stability. III. Disposal of stocks purchased from financial institutions The Bank implemented a stock purchasing program, which was not a monetary policy measure, between November 2002 and September 2004. Through this program, the Bank purchased stocks held by financial institutions in order to encourage them to reduce their market risks associated with stockholdings. The total book value of the stocks held by the Bank under this program was approximately 1.6 trillion yen as of the end of September 2007, and the Bank has started to dispose of these stocks in the market from October 2007 as scheduled. In disposing of them, the Bank will strive to avoid any financial losses and also to minimize the impact on the stock market by carefully spreading its sales out over a period. Conclusion Let me close my remarks by noting that in the latest issue of the Outlook for Economic Activity and Prices, which was decided and released on October 31, the Bank presented its assessment of economic activity and prices and its basic thinking on the future course of monetary policy that I have explained today.
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Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at a meeting with business leaders, Nagoya, 3 December 2007.
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Toshihiko Fukui: Developments in economic activity and prices and the Bank of Japan’s conduct of monetary policy Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at a meeting with business leaders, Nagoya, 3 December 2007. * * * Introduction Today, I would like to explain the Bank of Japan's view regarding developments in economic activity and prices and the basic thinking behind its conduct of monetary policy. In addition, I would like to touch upon the issues currently facing Japan's financial system. I. The current situation and the outlook for economic activity and prices I would first like to talk about the current situation and the outlook for economic activity and prices. Japan's economy as a whole has continued to expand moderately, although the pace of improvement in the household sector has remained slow relative to the strength in the corporate sector. At the end of October, we released the Outlook for Economic Activity and Prices (hereafter the Outlook Report), and presented the projection through fiscal 2008. The gist of the Outlook Report is that although there are uncertainties regarding overseas economies and global financial markets, Japan's economy is likely to continue its sustained expansion under price stability. In terms of the rate of real GDP growth, we projected that this is likely to register around 2 percent on average, somewhat higher than the potential growth rate. I would now like to elaborate on the mechanisms that form the basis for the outlook as well as some associated risk factors. Within the corporate sector, exports have remained on the increase, reflecting the widening base of continuing world economic growth. Business fixed investment is likely to keep rising steadily, supported by high corporate profits. The rate of growth is, however, likely to be lower than it was up until fiscal 2006, since capital investment has continued to increase at a rapid pace for the last several years. The positive influence of the strength in the corporate sector has been feeding through into the household sector slowly but steadily. With the number of employees rising, employee income has been increasing moderately, and growth in household income has continued to be further supported via various other channels, for example, increased dividends. Meanwhile, wages have been somewhat weak recently, reflecting labor cost restraint by firms in the face of greater exposure to global competition and capital market discipline, and increased materials prices. The change in the composition of the workforce due to the retirement of the high-salaried baby-boomer generation and increases in part-time workers has also contributed to the weakness in wages. However, given the further tightening of labor market conditions and firms' growing sense of labor shortage, upward pressure on wages is expected to increase gradually. Against this background, private consumption is likely to follow a moderate upward trend. In assessing wages and other flows of income from the corporate to the household sector, business conditions at small firms are especially relevant because small firms account for a large share of Japan's total employment. Since its inception, the current economic expansion has coincided with continued progress in globalization, and thus there has been disparity in business conditions depending on the extent of involvement with economies abroad. Recently released surveys indicate that business sentiment at small firms is weakening. Factors behind this include the deterioration in small firms' terms of trade, resulting from the surge in materials prices, and the fact that production remained virtually flat in the first half of 2007. Although production has been increasing since the summer, future developments in business conditions at small firms continue to warrant attention. Regarding prices, while the domestic corporate goods price index (CGPI) has been rising mainly due to higher international commodity prices, the year-on-year rate of change in the consumer price index (CPI, excluding fresh food) has remained at around 0 percent. This seems to reflect the fact that fierce competition due partly to progress in deregulation has not allowed firms at the retail level to pass increased materials prices on to consumers to the extent that has been possible at the wholesale level. Looking ahead, however, as economic growth is expected to continue at a rate somewhat higher than the potential growth rate, the level of utilization of resources, namely in labor and production capacity, should rise further, and unit labor costs (labor costs per unit of output) are likely to stop falling. Given this, the year-on-year rate of change in the CPI (excluding fresh food) is likely to be around 0 percent in the short run, but is expected gradually to rise in the longer run. II. Positive and negative deviations As I have outlined, the scenario we consider the most likely is that Japan's economy will continue its sustained expansion with a virtuous circle of growth in production, income, and spending in place. However, it should be noted that such projections are always subject to upside and downside risks, which warrant close attention. The first risk concerns developments in overseas economies. In the United States, housing investment has been decreasing, and, with inventory levels high, the correction in the housing market is expected to continue for a while. Banks are becoming increasingly cautious in extending loans in view of disruptions in financial markets due to subprime mortgage problems. Nevertheless, to date, other parts of the economy seem not to have been harmed significantly, and private consumption and business fixed investment are continuing their moderate upward trend, although the pace of increase is decelerating. Employment has also continued increasing. Given these developments, it seems likely that the U.S. economy will register relatively low growth rates in the short run but will eventually realize a soft landing and move toward sustainable growth. However, if the correction in the housing market intensifies or the negative effects of disruptions in financial markets become unexpectedly widespread, private consumption and business fixed investment may fall below expectations through negative wealth effects, credit tightening, and deterioration in business and consumer sentiment, thereby leading to further deceleration in U.S. economic growth. Meanwhile, the European economy has continued to expand, but the possible adverse effects on financial conditions of global financial market disruptions may pose a downside risk. If downside risks related to the U.S. and European economies were to materialize and have significant adverse effects, growth in other parts of the world may be hampered and this could cause global economic growth to be weaker than expected. At the same time, attention should also be paid to the risk of inflation, since the world economy, taken as a whole, has been expanding at a rapid pace. In the United States, underlying inflationary pressures do not seem to have subsided, reflecting continued high levels of resource utilization as well as developments in crude oil prices. In China, with signs of overheating, especially in fixed asset investment, economic growth and inflation may exceed expectations. Meanwhile, given the currently elevated prices of crude oil and grains such as wheat and soybeans, possible shifts in international commodity prices may also influence the outlook for the global economy and the price situation. In global financial markets, disruptions due to subprime mortgage problems have continued to be observed. In the United States and Europe, the functioning of markets for securitized products has deteriorated significantly, while money markets are still in the process of recuperating. Stock prices and foreign exchange rates have been unstable across the world. The recent volatility in global financial markets seems to reflect a reversal of the previous laxity in risk evaluation that had developed during the long period of benign economic and financial conditions. This adjustment is therefore expected to require some time to work itself out, and during the process financial institutions will have to bear a certain amount of losses. Still, there is a degree of uncertainty as to how the global economy will be influenced by future developments in global financial markets and conditions at financial institutions. If such disturbances to overseas economies and global financial markets should indeed materialize, Japan's economy may be adversely influenced through, for example, changes in exports and imports, corporate profits, and financial market conditions. Attention should continue to be paid to this potential risk. The second risk concerns possible larger swings in financial and economic activity under continuing accommodative financial conditions. In terms of their impact on Japanese financial conditions, the adverse effects of subprime mortgage problems and the consequent volatility in global financial markets have so far been limited: the lending attitude of financial institutions has been positive; and the issuing environment for CP and corporate bonds has continued to be favorable. Meanwhile, with extremely accommodative financial conditions continuing, there is a risk of a misallocation of resources in the long run as agents become over-extended in financial markets or pour funds and other resources into inefficient economic activities. Such behavior may push up economic growth and asset prices in the short run, but lead to later downward adjustments and hamper the sustainability of economic growth. III. Conduct of monetary policy I would now like to explain the Bank's thinking regarding the conduct of monetary policy based on the above-mentioned assessment of economic activity and prices. As I have just said, Japanese financial conditions have been extremely accommodative, and if Japan's economy is to follow a path of sustainable growth under price stability, the level of interest rates is to be raised. We have no predetermined view regarding the timing or the pace of increase in interest rates, and will determine these in light of our assessment of the future path of the economy and prices and its likelihood, as well as a careful consideration of both upside and downside risks. Our outlook suggests that Japan's economy will realize sustainable growth under price stability. But still, we need to examine the likelihood of this scenario. We are also aware of the importance of examining risk factors that may influence the outlook, and in this respect we should not focus merely on immediate downside risks, but should be attentive to both upside and downside risks. It is vital for monetary policy to adopt a wide-ranging perspective that takes due account of the various factors influencing economic activity and prices. This is something we bear in mind in our efforts to ensure the appropriate conduct of monetary policy. IV. Issues facing Japan's financial system As the last topic of my speech today, I would like to touch upon the recent volatility in global financial markets and its implications for Japan's financial system. As subprime mortgage problems have intensified and become more widespread in financial markets abroad, the impact on Japanese financial institutions has been gradually increasing and is greater than originally expected. For instance, the decline in the market value of investment products has resulted in losses at some Japanese financial institutions, and some financial institutions have posted losses from revaluation on unsold products arranged as part of their overseas securitization business. However, since Japanese financial institutions' exposure to credit markets is relatively small, it seems that so far each financial institution or financial group is able to absorb losses incurred sufficiently within its earnings for the period or its buffer capital. We will keep our eyes on developments in U.S. and European financial markets, but it currently seems unlikely that this particular problem will pose any significant threat to the stability of Japan's financial system. Based on the assessment I have just made, let me now turn to current issues relating to risk management by market participants. First, market participants, including financial institutions, need to assess the risks pertaining to financial products more precisely. It cannot be denied that the current disruptions in financial markets are due partly to lax risk assessment by market participants caught out by the rapid expansion of markets for securitized products as well as the increased market penetration of complex financial products whose riskiness is difficult to assess. Innovative new financial products, in particular, have only a limited amount of accumulated historical data, for example on price fluctuations, and they also have complex risk profiles and relatively low market liquidity. For this reason, market participants should seek to quantify risks as accurately as possible, subject to very strict stress testing, and should then conduct appropriate risk management accordingly. Second, market participants should further involve themselves in enhancing market transparency. As seen in recent events, once a significant shock has occurred, the market as a whole tends to suffer anxiety and it can take some time for the proper functioning of financial markets to be restored. Furthermore, market reaction seems to become larger where financial products traded incorporate more advanced financial technologies. From the viewpoint of minimizing market over-reactions and facilitating the prompt recovery of market functioning, initiatives by market participants to further enhance information disclosure are highly desirable. Greater market transparency could be achieved, for instance, through the disclosure by financial institutions of the outstanding amounts of their investments and information concerning their profits and losses, as well as the provision by rating agencies of detailed information relevant to credit ratings. I would like to emphasize that we do not view the recent development of financial markets, especially for securitized products, in a negative light. Risk diversification using new financial products has broadened the range of participants in financial markets, and has contributed significantly to the growth of the world economy. The problem has been that the techniques to assess and manage the associated risks have not kept up with the pace of product innovation. What we need is to improve those techniques. At the Bank of Japan, we will continue to closely monitor developments in global financial markets and to assess their implications for the Japanese financial system. At the same time, we will study and analyze in greater depth the various risk management issues I have discussed today, and so contribute to the enhancement of risk management by Japanese financial institutions. Closing remarks Amid intensifying global competition, Chubu, which has an industrial sector that is highly competitive at the international level, has been pulling the Japanese economy forward. I feel confident that the Chubu region will make use of the advanced technological expertise it has built up to take advantage of new business opportunities, and to enjoy further breakthroughs. I believe this will in turn lead to the sustained and dynamic growth of Japan's economy.
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Opening speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at a joint symposium of the Bank of France and the Bank of Japan, Paris, 8 January 2008.
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Toshihiko Fukui: Bank of France – Bank of Japan: converging views Opening speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at a joint symposium of the Bank of France and the Bank of Japan, Paris, 8 January 2008. * * * I am very happy to welcome you today to this conference organised to celebrate the 150th anniversary of Franco-Japanese diplomatic relations. Indeed, Franco-Japanese economic relations are of particular interest to all of you. The Bank of Japan opened its office in Paris in 1955. Since then, a large number of Bank of Japan staff members – including myself – have established strong ties with France thanks to the hospitality of the Banque de France and the pleasant atmosphere in Paris. I for one lived in Paris for about two years and half in the early 1970s, at the time of the Nixon shock that brought an end to the Bretton Woods system. The United States suddenly decided to suspend the convertibility of the dollar into gold. It was a Sunday. I clearly remember the efforts I expended during the talks with the Banque de France. What I learned in Paris is invaluable as it was a key experience for a central banker. The Banque de France counts a number of people with an in-depth knowledge of the Japanese economy. Amongst others, I would like to mention Mrs Denise Flouzat, former member of the Monetary Policy Council at the Banque de France, who will be chairing the afternoon session. In 2002, she published a book entitled “Japan: eternal revival?”, in which she assesses the strong potential of the Japanese economy to overcome the economic crisis at what was probably the worst time after the bursting of the financial bubble. The subsequent development of the Japanese economy confirms Mrs Flouzat’s perceptiveness. In 2003, the year following the publication of Mrs Flouzat’s book, I became Governor of the Bank of Japan. This book has clearly had a considerable influence on the way in which I have conducted monetary policy in Japan. Both France and Japan have a very rich culture, underpinned by their long history. They have established a constructive relation, learning from each other in many fields. For example, in the field of art, a considerable number of painters, such as Léonard Fujita, have studied oil painting in Paris. Conversely, illustrious impressionist painters, such as Claude Monet, drew their inspiration from the Japanese etchings. Everyone knows that art in France has been strongly influenced by Japanese culture. As regards gastronomy, there are now a large number of Japanese restaurants in Paris. French cuisine has drawn on Japanese cuisine, and vice-versa. Rather than simply perpetuate their traditions, Japanese and French chefs seek to extend the realm of nouvelle cuisine. Japan and France have established a particularly constructive relation in many economic spheres. The two topics of today’s conference are the Banque de France and the Bank of Japan: construction and co-operation and the French and Japanese economies in a globalised world. As an introduction, I will make a few comments on the co-operation between the two central banks in the context of economic globalisation. France has played a very important role from the start of the Meiji era in Japan in the mid 19th century, when the country became a player on the global economic scene. Thanks to France’s financial and technological assistance, a major shipyard and port infrastructures were set up in the town of Yokosuka. This is one of the initiatives that marked the start of Japan’s co-operation with third countries in the process of industrial modernisation in Japan. France also played a role at the time of the creation of the Bank of Japan. Mr Léon Say, Minister of Finance at the time, advised Mr Masayoshi Matsukata, an influential member of the Japanese government who was studying central banking in Europe, to refer to the newlyestablished National Bank of Belgium. His contribution was highly significant. Later, when the Bank of Japan was drawing up its statutes, the Japanese government drew on the statutes of the National Bank of Belgium and the regulations of the Banque de France. Economies have become increasingly globalised over the past century and a half. Recently, the pace of globalisation has even accelerated. Borders are melting away and are no longer an obstacle to economic activity. Franco-Japanese relations should not be looked at solely from the angle of trade and capital flow statistics. It would be wiser to say that France and Japan are two major intertwined economic centres on the global stage. This globalisation process has a significant impact on the primary objective of a central bank’s monetary policy, which consists in ensuring price and economic stability. It is now impossible for all central banks to assess the economic situation without taking a look at global economic trends. In addition, the globalisation process in the area of financial transactions is much faster and deeper than in trade in goods and services. If a shock occurs in one country, it will immediately spill over onto numerous other financial markets. In this context, central bank co-operation is becoming increasingly important. In fact, strong ties have been established at various levels. I myself have continued to participate in the Governors’ meetings of the Bank for International Settlements, a discussion forum for central banks. It is a pleasure for me to talk to Mr Noyer and other central bank governors at the meetings, which are not only an opportunity to exchange information on the state of the economy and prices, but also to tackle problems specific to each country and international topics of common interest. I set great value on my colleagues’ ideas and suggestions and feel solidarity with them because we are bound by our common objective, supporting the global economy. At the same time, central banks seek to emulate each other, i.e. they seek to draw lessons from each other’s experience and endeavour to always adopt the best practices. In this process, there is no patent. Actually, it is in our interest that all countries conduct an appropriate monetary policy because it is a guarantee of global economic stability. This is why central banks are committed to passing on their own experience. For example, central banks have been striving to make their monetary policy more transparent. Since the 1990s, central banks have achieved greater autonomy from the State in a large number of countries and regions, including Europe and Japan. At the same time, central banks are required to be more transparent and accountable for the conduct of monetary policy. Increased transparency is important because it enhances the effectiveness of monetary policy by anchoring the expectations of households, companies and financial market participants. Having acknowledged the need for greater transparency, banks have endeavoured to take the most appropriate measures to better explain their monetary policy and better communicate with financial markets, taking into account the economic and social situation of their country. To do so, banks have drawn on each other’s experiences. One fundamental issue is how to define price stability, which is the primary objective of monetary policy. This involves striking a balance between the need for clarity and the need for monetary policy flexibility. Each country has worked out its own solution to this tricky problem. A number of countries, including the United Kingdom, have adopted a policy of inflation targeting, whereby the central bank sets a target inflation rate. In this case, measures are adopted gradually to ensure sufficient flexibility. The European Central Bank, set up in 1998, defines price stability in terms of the year-on-year increase in the Harmonised Index of Consumer Prices and relies on a reference value for monetary growth. The Bank of Japan adopted a new monetary policy framework in 2006. It publishes an inflation rate that reflects the Policy Board members' understanding of medium- to long-term price stability. In line with this understanding, we examine the most likely outlook and assess risks most relevant to the conduct of monetary policy, which we call the two-perspective approach. In November 2006, the FED published a series of measures aimed at enhancing its communication strategy. One of them consisted in extending the economic and price forecasting horizon to three years. A three-year inflation forecast shows the inflation rate that the Federal Open Market Committee considers consistent with the objectives of the FED, i.e. price stability and maximum employment. These frameworks were devised by taking account of other countries’ experiences and retaining the most suitable elements for their own economy. I believe that, in this area, central banks will increasingly draw on the experiences of other countries. Countries share the same understanding of problems but at the same time stick to their uniqueness when taking decisions. This holds true in the area of monetary policy but also in numerous other areas within the evolving field of international relations. As in the case of art and gastronomy, which I talked about at the start of my speech, mutual influences lead to new innovations and blur borders through mutual understanding. This does not mean that we lose our uniqueness. In today’s conference, we will take a look at the economic and financial growth patterns of both France and Japan and examines in-depth the economic problems with which each country is faced in the context of globalisation. I hope that it will give rise to a better mutual understanding of both economies and foster further emulation. Thank you very much for your attention.
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Summary of a speech given by Mr Kazumasa Iwata, Deputy Governor of the Bank of Japan, at the Panel Session "Recent and Prospective Developments in Monetary Policy Transparency and Communications: A Global Perspective," at the Allied Social Science Associations Annual Meeting, New Orleans, 5 January 2008.
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Kazumasa Iwata: Transparency and communication policy in Japan Summary of a speech given by Mr Kazumasa Iwata, Deputy Governor of the Bank of Japan, at the Panel Session "Recent and Prospective Developments in Monetary Policy Transparency and Communications: A Global Perspective," at the Allied Social Science Associations Annual Meeting, New Orleans, 5 January 2008. * * * Introduction 1. Following the introduction of the new Bank of Japan Law in 1998, the Bank's de-jure independence has been significantly strengthened. The Board members can be confident of making decisions independent of interference from outside the Bank, although the rationale, the process and the consequences of those decisions are exposed to the critical eye of the media, the BOJ-watchers and the politicians. The independence, together with the long-term tenure, allows the decision making of the BOJ a longer time horizon. This should enable the BOJ to carry out its tasks with both transparency and flexibility. At the same time, in a democratic society, the responsibility to fulfill the mandate of policy objectives is increased; that is to say, this independence is accompanied by accountability. A lack of transparency in the decision-making process may easily lead to a deficit of accountability. In addition to the clarification of monetary policy objectives, central banks provide the framework for communication about the justification for their decision. Moreover, to gain the benefits of providing an anchor for expectations regarding the future inflation rate, some central banks are even willing to clarify the future course of monetary policy based on their economic forecast. Transparency is needed not only for achieving accountability, but also to make the effect of monetary policy more efficient through market expectation channels. The communication policy, if it is managed successfully, serves to enhance transparency. Objectives 2. For today's panel discussion, let me take up some issues of transparency and communication policy in the light of recent experience in Japan. While the issues cover several aspects including (1) objectives, (2) procedures, (3) economic analyses, (4) actions and (5) policy instruments, I will focus on two of them, namely, the objectives and instruments. 3. The new Bank of Japan Law states that, "currency and monetary control shall be aimed at, through the pursuit of price stability, contributing to the sound development of the national economy" (Article 2). The dual mandate of sustainable growth under price stability is similar to the "maximum employment and price stability" mandate of the Federal Reserve. It is different from the hierarchical or lexicographic ranking of the ECB which attaches overriding importance to maintaining price stability (Papademos(2006)). Quantitative easing policy 4. Despite the dual mandate, under the quantitative easing policy regime of the period covering March 2001 to February 2006, the primary objective was focused on the restoration of price stability or the exit from the deflation which had persisted since late 1998. The other important objective was to stabilize the financial system. The Bank of Japan made a commitment to continue the zero interest rate policy unless the rate of change in consumer prices moved above zero in a stable manner. More precisely, the Monetary Policy Committee in October 2003 made the conditions for exit more transparent. Namely, the following three conditions must be satisfied before ending the quantitative easing policy: (1) the current rate of change in consumer prices moves up above zero (2) the rate of change in consumer prices does not return to negative territory, (3) there may be a case that the BOJ will judge it appropriate to continue the zero interest rate policy, even though the first two conditions are satisfied. The explicit commitment on the duration of zero interest rate policy worked to lower longerterm interest rates. Increasing bank reserve targets strengthened the "time duration effect" which relied solely on market expectations of future developments in policy rates in the absence of any actual change in policy rates (Iwata(2005)). New policy framework 5. After confirming the development of an above-zero inflation rate, the BOJ exited from the quantitative easing policy in March 2006. At the time of the exit, the Bank announced a new policy framework. In this framework we provided the "understanding of medium- to long-term price stability" in a numerical form conceived by the Board members. It ranges from 0% to 2% with the distribution above and below the median value of 1%. This longer-run price stability concept can be regarded as a natural consequence arising from the second condition under the quantitative easing policy. This "understanding of medium- to long-term price stability" is common knowledge among the Board members. It is not only shared knowledge, but also everybody knows that the others know it. Provision of common knowledge serves as a focal point to coordinate human action. 6. Thomas Schelling (1960) illustrated the role of focal points using the following situation as a whimsical example: "When husband and wife, separated in a department store, gaily traipse off to the "Lost and Found". Likewise, if we can correctly communicate the Board members' common knowledge to market participants and the general public, then we might expect that it can be also shared among market participants, and thus as a result, we can presume that market expectations will converge on the longer-run price stability. 7. If we look at the fan chart, we can see that our "understanding" is different from the "inflation target" adopted by the Bank of England, which seems to aim at achieving a 2% target after 8 quarters. We have no specific time horizon attached to our "understanding". Furthermore our "understanding" is also different from the ECB's numerical definition of price stability over the medium-term ("below 2%, but close to it") in the sense that the Board members' opinions determine the numerical range. If there is a change in the membership of the Board, then the range also changes. Further, it is also possible that our "understanding" changes to reflect changes in the structure of the economy. Within our framework it is possible to revise the numerical range regularly. So far there has not been any change in the numerical range of our "understanding", despite routine changes in Board membership. Two perspectives approach 8. The new policy framework is entitled the "two perspectives approach", in contrast to the "two pillars approach" advocated by the ECB. The first perspective examines whether the outlook deemed most likely by the BOJ follows a path of sustainable growth under price stability within the forecast period, while the second provides an assessment of various risks, including low-probability events which can cause serious damage to the economy beyond the forecast time horizon. The latter perspective shares features in common with the "risk management approach" urged by former Federal Reserve Chairman Alan Greenspan 1 . Transparency and flexibility 9. Keeping in mind the "understanding of medium- to long-term price stability", we make policy decisions by examining the plausibility of our scenario presented in the semi-annual outlook and by assessing the various risks and the uncertainty ahead for our economy. As the plausibility of forecasts and the examination of risks play a key role, the new policy framework can be broadly described as a "forecast-based policy" which is inherently forwardlooking (Bernanke(2004)). The publishing of projections, and the related explanations and reasoning, contributes to enhancing the transparency of decision procedures. By adopting the new policy framework we have restored the flexibility of monetary policy management, while enhancing the transparency both of policy objectives and decision procedures. Under the quantitative easing policy regime, the flexible management of monetary policy was seriously undermined; developments in real economic activity mattered only to the extent that they cause upward/downward pressure on prices. There was also the risk of financial imbalance and resource misallocation due to the mounting market expectation of permanently low interest rates. 10. Given the institutional framework of consensus formation at the Monetary Policy Meeting, our "understanding", which reflects the opinions of the Board members, is suitable for maintaining democratic order and supporting individual accountability. In addition, the longerrun time horizon of price stability allows more flexibility in monetary policy management. On the other hand, this practice may raise the issue of dynamic (inter-temporal) inconsistency or self-consistency. If the communication policy fails to achieve its role of transmitting the Board members' common knowledge correctly to market participants and the general public, the role of transparency may be significantly eroded. Before discussing the role of communication policy, I would like to take up the issue of transparency of policy instruments, namely the announcement of the future development of policy rates, because this practice is presumed to enhance transparency significantly, and several countries have adopted it, for instance, New Zealand, Norway and Sweden. Instruments: policy rate projections 11. Under the quantitative easing policy regime, transparency in regard to policy instruments was extremely high, as was expressed by the above-mentioned three conditions. Moreover, the assumption of the constant policy interest rate in providing forecast could be easily justified, as long as the inflation rate was expected to remain below zero. 12. But the assumption of the constant policy rate is no longer adequate since exiting the quantitative easing policy. We have added the footnote to the Forecast Table, as of April 2006, that we take into account market expectations on future policy rates. In other words, we have adopted the approach that each individual Board member assumes the appropriate path of future policy interest rates in providing the figures for forecast (real GDP, core CPI and CGPI over a two-year time horizon), thereby taking into account market expectations on the future development of policy rates. It seems reasonable to pay due attention to market expectations, because current asset prices reflect market expectations on the future development of policy rates. In my understanding, the decision at the Monetary Policy Committee is made when the majority On the relation between the asset price bubble and the second perspective, see Iwata (2007). view is formed on the appropriate timing of policy interest rate changes after examining the plausibility of the scenario embodied in the forecast and assessing the various risks both in the short- and longer-run. Whether it is desirable or not to publish the appropriate path of future policy rates in achieving the goals of the mandate depends on judgments regarding noise in public information, the limits of transparency, the possibility of distorted communication and our limited knowledge about structural changes in the economy. Communication policy 13. Monetary policy becomes more effective, if the communication policy succeeds in coordinating market expectations by providing the public information as a signal. Yet, it is possible that the public information is imperfect and contains noise. Take the example of focal points illustrated by Schelling. If the focal point is unique, then it is easy to bring expectations into convergence. But if there are several focal points, it may not be easy to stabilize market expectations 2 . In addition, there may be cases where market participants find it difficult to delineate the consensus view and the minority view which is expressed to demonstrate individual accountability. Furthermore, if the common knowledge shared by Board members or the public information is imprecise, as compared with the private information, the signaling by the central bank can have an adverse effect on welfare. There may be a limit to transparency, if the provision of public information can cause an overreaction in market participants (Morris and Shin(2002)). It is also possible that the public information contains noise or the precision of public information is significantly lower than the private information 3 . Nobody would recommend broadcasting Monetary Policy Meeting discussions. 14. Deputy Governor of the Swedish Riksbank, Lars Svensson (2007) proposed the announcement of the loss function of central banks and making voting on the relative weight attached to two objectives; namely the deviation of the inflation rate and the GDP gap on the future path of economic development. He recommends preannouncement of the path of policy rates to minimize the present value of the loss function. Yet it seems to be premature to put preannouncement into practice at the present time in conducting Japanese monetary policy. First of all, there are doubts as to whether communication with the general public can be carried out in an undistorted way 4 ; specifically, it may not be easy to convince market participants that the announced path of policy rates is conditional, and is not a promise. Second, there is a measurement problem. In addition to the GDP gap, there is uncertainty over the measurement of the relevant parameters. There are two critical parameters for minimizing future loss; namely, the relative weight in the loss function and the sensitivity of price changes to changes in the GDP gap. The ratio of these parameters is equal to the marginal rate of transformation between the two objectives (inflation rate and the GDP gap) For instance, we could mention the entrance of the department store through which husband and wife passed. Or there may be several "Lost and Found" offices. Then the power to bring expectations into convergence weakens. If some market participants perceive that the desired inflation rate set by the BOJ is the lower limit of the price stability range, namely 0%, while others regards the upper limit as the desired one, then the signal to stabilize expectations may be muted. Svensson (2006), commenting on Morris and Shin's paper, argued that the provision of public information diminishes welfare only if the precision of public information is eight times lower than the private information, or the amount of noise is more than eight times the amount of noise in the private information. Otherwise, more transparency increases the welfare. Habermas (1992) argued that the validity of the political decision-making process can be secured by democratic discourse under circumstances facilitating "undistorted communication" among voters. on the policy possibility frontier. The value of the former parameter is determined by voting, while the value of the latter parameter can be gauged from the instantaneous sacrifice ratio, by which I mean the inverse of the slope of the aggregate supply function in the macroeconomic analysis. One of the problems is the fact that the slope of the aggregate supply curve can change, partly reflecting the effect of globalization, as shown in Figure 1 5 . An alternative way to derive the ratio is to estimate the elasticity of demand faced by monopolistically competitive producers, as pointed out by Woodford (2007) 6 . Yet the values obtained from the two approaches, macro- and micro-economic analysis, can differ widely. Given the limited knowledge about the key parameters and the uncertainty of measurement, I would hesitate to preannounce the path of future policy rates, although I do not deny the usefulness of examining the intertemporal consistency and the robustness of policy decisions by employing different parameters. 15. Finally, communication can be made through action. The power of action can be stronger than words in persuading market participants. Schelling once noted that "to communicate a commitment requires more than the communication of words...One has to communicate Borio and Filardo (2007) argue that the changes in GDP gap in foreign countries make the slope of the aggregate supply function flatter, while a study by staff of the Federal Reserve does not support the evidence on the effect of globalization (Ihrig, Kamin, Lindner, Marquez(2007)). We need to collect more microeconomic empirical evidence in assessing the price setting behavior of Japanese firms, including the issue as to whether Calvo-type or Taylor-type staggered price adjustments are made. evidence that commitment exits". It is important to implement monetary actions in a consistent manner based on the fundamental framework notably under the circumstances of imperfect public information. Conclusion 16. The new policy framework of the BOJ has improved both transparency and flexibility. There is room for further improvement in transparency and communication policy. Yet, we should be mindful of the limits of our knowledge and of transparency, as well as of the liability to distortion of communication in the process of consensus formation on decision making. References [1] Bernanke, B.S., "The Logic of Monetary Policy," remarks before the National Economists Club, December 2004. [2] Borio, C., and A. Filardo, "Globalisation and Inflation: New Cross-Country Evidence on the Global Determinants of Domestic Inflation," Working papers No. 227, Bank for International Settlements, 2007. [3] Habermas, J., "Between Facts and Norms: Contribution to a Discourse Theory of Law and Democracy," MIT Press, 1992. [4] Ihrig, J., Kamin, S. B., Lindner, D., and J. Marquez, "Some Simple Tests of the Globalization and Inflation Hypothesis," International Finance Discussion Papers, No. 891, Federal Reserve Board, April 2007. [5] Iwata, K., "The Role of the Price Stability Anchor in Extricating Japan from Deflation," at the Symposium sponsored by the Federal Reserve Bank of Kansas City, August 2005. [6] Iwata, K., "Housing and Monetary Policy in Japan," at the Symposium sponsored by the Federal Reserve Bank of Kansas City, September 2007. [7] Morris, S., and H.S. Shin, "Social Value of Public Information," American Economic Review, Vol. 92, No. 5, 2002. [8] Papademos, L., "Central banks in the 21st century," speech at a conference on "Central banks in the 21st century" organized by the Bank of Spain, Madrid, 8 June 2006. [9] Schelling, T.C., "The Strategy of Conflict," Harvard University Press, 1960. [10] Svensson, L.E.O., "Social Value of Public Information: Comment: Morris and Shin Is Actually Pro Transparency, Not Con," American Economic Review, Vol.96, No. 1, 2006. [11] Svensson, L.E.O., "Optimal Inflation Targeting: Further Developments of Inflation Targeting," in Frederic Mishkin and Klaus Schmidt-Hebbel, eds., Monetary Policy under Inflation Targeting, Santiago: Central Bank of Chile, 2007. [12] Woodford, M., "Forecast Targeting as a Monetary Policy Strategy: Policy Rules in Practice," paper prepared for the conference "John Taylor's Contributions to Monetary Theory and Policy," Federal Reserve Bank of Dallas, October 2007.
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Summary of a speech by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, at a meeting with business leaders, Sapporo, 10 January 2008.
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Toshiro Muto: Bank of Japan's view regarding developments in economic activity and prices and the thinking behind its conduct of monetary policy Summary of a speech by Mr Toshiro Muto, Deputy Governor of the Bank of Japan, at a meeting with business leaders, Sapporo, 10 January 2008. * * * Introduction Today, I would like to discuss the Bank of Japan's view regarding developments in economic activity and prices and the thinking behind its conduct of monetary policy. I. The current situation and the outlook for economic activity and prices I would first like to talk about the current situation and the outlook for economic activity and prices. The pace of growth in Japan's economy is currently slowing, mainly due to the drop in housing investment. The economy, for the time being, is expected to continue slowing, but is likely to resume moderate expansion thereafter. The December Tankan (Short-Term Economic Survey of Enterprises in Japan) indicated that businesses have become somewhat more cautious. Factors behind this seem to include the following. First, small firms, in particular, are still unable to pass on higher costs to sales prices even though the steep rise continues in prices of materials such as crude oil and grains. Second, housing construction has decreased significantly, reflecting the coming into force of the revised Building Standard Law in June last year. And third, uncertainty regarding the future course of the world economy has increased due to subprime mortgage problems. However, overall, firms are maintaining their growth forecasts for income and profits for fiscal 2007 and their capital investment plans remain solid. Production has started increasing again after staying flat during the first half of 2007. The adjustment in inventories of IT-related goods, which had been rising, has more or less come to an end, and levels of production, shipments, and inventories, including in the IT-related sector, are essentially well in balance. Despite increased uncertainty regarding the course of the global economy and especially the U.S. economy, exports to a broad range of regions, including the oil producing countries and emerging economies, and hence overall, are continuing to increase. In the December Tankan, large firms' annual projections for export sales have been revised upward. Given these developments, it seems reasonable to conclude that the strength in corporate activity remains intact, although close attention should be paid to how the more cautious business sentiment will affect corporate spending activity. Let me now turn to developments in the household sector. Nominal wages per worker have been somewhat weak. Labor cost restraint by firms is persistent, as they are facing greater exposure to global competition and capital market discipline. Recently, in particular, sluggish growth in corporate profits resulting from the surge in materials prices has been leading firms, especially small ones, to restrain wages. Moreover, the change in the composition of the workforce, resulting from the fact that the high-salaried baby-boomer generation started to retire in 2006 and from increases in the share of part-time workers, has also contributed to the weakness in wages. However, as the economic expansion continues, albeit at a moderate pace, many firms are feeling a shortage of labor, as suggested by the Tankan reports, and the number of employees continues to rise. If labor supply and demand conditions continue to tighten, it is likely that upward pressure on wages will gradually increase. This implies that employee income, which is the product of the number of employees and wages, is likely to continue rising moderately. Against this background, private consumption has been firm. Although weather conditions have caused sales at department stores and at supermarkets to stay virtually flat, sales of digital appliances have been strong and the number of new passenger-car registrations has picked up. Meanwhile, however, various survey results are indicating weaker consumer sentiment. Factors behind this seem to include rises in prices of daily necessities such as gasoline, kerosene, and food, while wages remain sluggish. Developments in private consumption, which may be influenced by the weaker consumer sentiment, should continue to be monitored carefully. Meanwhile, housing investment has been showing substantial declines due to the delays in the confirmation of building applications after the revised Building Standard Law came into force. Going forward, it is expected that gradual recovery will take place as the delays in the confirmation process are resolved, but there are uncertainties regarding the pace and extent of the recovery because condominium sales are becoming sluggish due to the rise in real estate prices, especially in the Tokyo metropolitan area. Regarding prices, the domestic corporate goods price index (CGPI) has been rising mainly due to higher international commodity prices. The year-on-year rate of change in the consumer price index (CPI, excluding fresh food), which had remained at slightly below 0 percent, posted an increase of 0.1 percent in October 2007, followed by a 0.4 percent increase in November. As prices of petroleum products and food are increasing, the rate of growth in the CPI is likely to rise further in the immediate future. As I noted earlier, the pace of economic growth seems to be decelerating at present. Given this, the overall supply and demand conditions seem unlikely to tighten for the time being. However, from a longer-term perspective, prices are likely to continue their upward trend due to tighter supply and demand conditions as the economic expansion continues. In sum, negative factors such as (1) the surge in materials prices, (2) the significant decline in housing investment, and (3) increased uncertainty regarding the course of the global economy are causing a deceleration in the growth of Japan's economy, which has been moderate to begin with. For this reason, the virtuous circle of growth in production, income, and spending is temporarily weakening, but we do not expect that it will break. The current economic expansion is attributable to the continuing growth in overseas economies and the progress in the adjustment of various excesses at firms and financial institutions in Japan. Export activity, which is supported by overseas economies, and production at present are continuing to increase, so that the driving force of the virtuous circle remains intact. The extent of progress in corporate restructuring varies depending on the industry and size of firms concerned, but looking at the corporate sector as a whole, firms are not under pressure to adjust production capacity, labor, and inventories. Under these circumstances, business fixed investment and private consumption are maintaining their upward trend. In addition, going forward, housing investment seems likely to gradually recover, since the sharp decrease in housing investment is mainly due to the procedural change following the coming into force of the new law. Given these circumstances, our current view is that Japan's economy will maintain its moderate upward trend. II. Developments in overseas economies It should be noted, however, that there are certain risks regarding the outlook I just mentioned. In particular, one important risk factor is whether the world economy will continue its sustained growth, since this is the basis for the virtuous circle driving Japan's economic expansion. Since summer 2007, global financial markets have been volatile due to the U.S. subprime mortgage problems, and uncertainty regarding the future of the world economy, especially the U.S. economy, has been increasing. The deceleration in the growth of the U.S. economy is becoming somewhat more pronounced. Housing investment continues to decrease substantially, and the drop in home sales and accumulation of unsold houses are becoming increasingly severe. According to survey results, banks are applying tighter terms and conditions not only on mortgage loans but also on real estate loans for business properties and on corporate and consumer loans. Recently released labor market statistics indicate that the pace of increase in employment has decelerated and the unemployment rate has risen. In this situation, however, private consumption and business fixed investment are so far continuing their moderate upward trend, although the pace of increase is decelerating. It seems likely that the U.S. economy will register relatively low growth rates in the short run but will gradually return to a path with growth rates close to the potential rate as the housing market correction progresses. However, the risk should be borne in mind that depending on future developments in the housing market correction and in global financial markets, private consumption and business fixed investment may fall below expectations through negative wealth effects, credit tightening, and deterioration in business and consumer sentiment, thereby leading to further deceleration in U.S. economic growth. The European economy continues to expand, with business fixed investment and private consumption maintaining their upward trend. However, the possible adverse effects on financial conditions of global financial market disruptions may pose a downside risk. Meanwhile, emerging economies and oil producing countries have been expanding robustly and are playing a more significant role as pillars of world economic growth. Thus, it seems reasonable to expect that thanks to the widening base of growth the world economy will continue to expand robustly. However, downside risks to this outlook are growing, reflecting intensified adjustment in the U.S. economy and in global financial markets. At the same time, attention should also be paid to the risk of inflation. In the United States, inflationary pressures are remaining, reflecting continued high levels of resource utilization, namely in labor and production capacity. In China, the economy continues to expand strongly, and there are signs of overheating, especially in fixed investment, despite various measures taken by the authorities to cool down the economy. The strong growth of the global economy and other factors, such as geopolitical risks and the speculative inflow of funds to commodity markets, are causing international commodity prices to remain elevated, as evidenced by the fact that crude oil prices temporarily rose above 100 dollars per barrel at the beginning of the year. Thus, countries around the world face difficult monetary policy challenges in the presence of both downside risks to the economic outlook and upside risks to inflation. III. Developments in global financial markets Global financial markets remain unstable, reflecting the downgrading of securitized products and persistent concern about possible further losses at financial institutions. The functioning of markets for securitized products has remained impaired as evidenced, for example, by continued decreases in the amount outstanding of asset-backed commercial paper (ABCP) issued and sluggish trading of collateralized debt obligations (CDOs). Corporate bonds have been issued at a reasonable pace, but the corporate bond market is still undergoing adjustment as seen in increased issuance spreads. Stock markets are still unstable, and stock prices declined substantially around the turn of the year. The volatility in global financial markets seems to reflect a market correction following the laxity in risk evaluation that had developed during the long period of benign economic and financial conditions. This adjustment is therefore expected to require some time to work itself out, and during the process financial institutions will have to bear a certain amount of losses. Since summer 2007, organizations such as the International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD) have released their estimates of the size of losses incurred from financial products related to subprime mortgage loans, but it is difficult to accurately grasp the amount of final losses, since the correction in the housing market is ongoing. Financial institutions in the United States and Europe have been posting considerable losses, and many have announced measures to boost their capital to compensate for these losses. How successful these measures are in helping financial institutions and the financial system to restore their credibility will need to be monitored closely. Short-term funding markets in the United States and Europe were under elevated pressures in late 2007 as financial institutions tried to secure end-of-year funds. To address this situation, on December 12 central banks in the major economies announced joint measures to ensure the stability of global financial markets. The Federal Reserve established a temporary Term Auction Facility. Under this facility program, the Federal Reserve can auction term funds against a wide variety of collateral, thereby providing funds with longer maturities to more financial institutions. Moreover, it established foreign exchange swap lines with the European Central Bank and the Swiss National Bank, and based on this, U.S. dollar auctions were carried out in Europe. The Bank of England and the Bank of Canada actively conducted operations to provide ample term funds with maturities beyond year-end. The Bank of Japan and the Swedish Riksbank welcomed the action and issued a press release stating that they would also appropriately provide liquidity to money markets in their respective countries. The Bank of Japan did not make any particular changes to its framework of money market operations because we have been providing funds with various maturities against a wide variety of collateral and are able to gauge funding needs by monitoring market participants' daily financing activities, and we can thus fully address the situation under the current framework. The joint action was based on the central banks' common understanding that, given the continued volatility in global financial markets, it was necessary to appropriately address elevated pressures in short-term funding markets and thereby facilitate the market adjustments in an orderly manner. Since the announcement of the measures, the central banks involved have been implementing market operations accordingly, and as a result interest rates on term instruments declined toward the end of 2007 in the United States and Europe. I believe these efforts will contribute to ensuring the stability of global financial markets. IV. Conduct of monetary policy I would now like to explain the Bank's thinking regarding the conduct of monetary policy based on the outlook for economic activity and prices and risk factors I have described. As I have often noted in the past, the Bank has been taking monetary policy actions in accordance with changes in the economic and price situation and has no predetermined view regarding future actions. In making judgments on policy actions, we try to accurately forecast future developments in the economy and prices, taking account of the time lags until policy actions actually influence the economy and prices – the so-called transmission lag of monetary policy. This is the essence of a forward-looking monetary policy. Let me explain this in the context of the current economic situation in Japan where, as I mentioned, the economy for the time being is likely to decelerate while the year-on-year rate of increase in the CPI will gradually rise due to increases in the prices of petroleum products and food. In conducting monetary policy, it is necessary to anticipate how these developments will affect future economic activity and prices. For example, in the current context, monetary policy judgments should be made based on the careful analysis of the following issues, which will be incorporated in the future assessment of the economy and prices: (1) whether the slowdown is temporary and the economy can be expected to return to its growth path, or whether there is a possibility that it will last longer than expected; whether price rises could exert a negative influence on the economy, leading to future downward deviations in the economy and prices; and (3) whether, on the contrary, price rises could push up future prices through their influence on households' inflation expectations or firms' price-setting behavior. It goes without saying that forecasts always entail uncertainty, making it all the more important to assess their likelihood as well as the risks of upward or downward deviations. We are determined to conduct appropriate monetary policy with the aim of achieving sustainable growth under price stability while carefully assessing our projections, their likelihood, and upside and downside risks. If, as a result of such assessment, it is judged that Japan's economy will continue its sustained expansion under price stability, interest rates, which currently are extremely accommodative, will be adjusted gradually. It is conceivable that if, for instance, the expectation takes hold that interest rates will remain low for a long time regardless of developments in economic activity and prices, there is a medium- to long-term risk of larger swings and an inefficient allocation of resources as firms and financial institutions overextend themselves. However, with regard to specific policy actions, we would like to proceed with discretion based on an open-minded, forward-looking assessment of the economic and price situation. Closing remarks Thus far, I have explained the current situation and the outlook for Japan's economy as well as the Bank's thinking on the conduct of monetary policy. In closing, I would like to devote attention to the economy of Hokkaido. The most notable characteristic of Hokkaido is its rich and boundless natural environment. However, as a consequence, Hokkaido's economy relies to a large degree on public works such as road construction and flood prevention. The reduction in these works as a result of the financial difficulties of the central and the local government means that economic growth has been sluggish relative to other parts of Japan. However, promising initiatives that take advantage of Hokkaido's rich natural resources are currently underway. Primary industry accounts for a large share of Hokkaido's economy, and in agriculture, for example, the promotion of organic farming and the introduction of a certification system for "Hokkaido Brand" products are achieving progress against the background of rising concerns about food safety. Moreover, with numerous colleges and research institutions working on bio-technologies, there are moves to produce new products that combine Hokkaido's rich resources in agriculture, forestry, and fisheries with new biotechnologies. Furthermore, the Hokkaido Toyako Summit will be held in July this year with environmental problems as one of the major themes. Hokkaido has already implemented a number of steps to take the lead in addressing environmental issues. For example, in the area of energy supply, work has been in progress in fields such as wind and solar power generation, biomass power generation in central Hokkaido – which has a large dairy farming industry – and the utilization of snow-ice cryogenic energy in regions with heavy snowfall, using snow and ice stored in winter for air-conditioning in summer. All of these efforts take full advantage of the region's distinguishing features and are friendly to the environment. The summit is a perfect opportunity to showcase Hokkaido's industries and natural environment, not only domestically but also to the rest of the world. I hope this will bring about steady progress in the revitalization of the regional economy.
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Statement by Mr Toshihiko Fukui, Governor of the Bank of Japan, concerning the Bank's Semiannual Report on Currency and Monetary Control, before the Committee on Financial Affairs, House of Representatives, Tokyo, 11 January 2008.
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Toshihiko Fukui: Overall review of the Bank of Japan’s conduct of monetary policy Statement by Mr Toshihiko Fukui, Governor of the Bank of Japan, concerning the Bank's Semiannual Report on Currency and Monetary Control, before the Committee on Financial Affairs, House of Representatives, Tokyo, 11 January 2008. * * * Introduction The Bank of Japan submitted its Semiannual Report on Currency and Monetary Control for the first half of fiscal 2007 to the Diet on December 11, 2007. I am pleased to have this opportunity to present an overall review of the Bank's conduct of monetary policy. I. Developments in Japan's economy Japan's economy is expanding moderately as a trend, although the pace of growth seems to be slowing mainly due to the drop in housing investment. Housing investment has dropped substantially, affected by the revised Building Standard Law coming into force. With higher materials prices, business sentiment has become somewhat cautious. Exports, however, have continued to increase in a situation where overseas economies continue to expand with momentum being gained across a wide range of economies. Business fixed investment has also continued to trend upward against the background of generally high corporate profits. Inventories have been more or less in balance with shipments, and there has not been adjustment pressure on production capacity and labor. With regard to the household sector, although nominal wages per worker have been somewhat weak, employee income has been rising moderately with the increase in the number of employees. In this situation, private consumption has been firm. Reflecting the rise in domestic and external demand, production has continued to increase. These developments seem to indicate that a virtuous circle of growth in production, income, and spending has basically remained in place. Therefore, Japan's economy is expected to continue expanding moderately, although for the time being the pace of growth is likely to slow in a situation where housing investment is likely to remain sluggish. Global financial markets, meanwhile, have remained unsettled due to the U.S. subprime mortgage problem. The functioning of markets for securitized products has deteriorated significantly in the United States and Europe, and stock markets have continued to be unstable worldwide. Moreover, uncertainty regarding global economic developments, for example, downside risks to the U.S. economy, has been increasing. The Bank considers it necessary to continue to monitor carefully developments in global financial markets and the global economy, as well as the effects from the rise in materials prices, such as the surge in crude oil prices. The three-month rate of change in the domestic corporate goods price index has been positive, mainly due to the rise in international commodity prices. The year-on-year rate of change in the consumer price index (excluding fresh food) became positive in October 2007, registering 0.1 percent in that month and 0.4 percent in November. As for the outlook, it is projected to follow a positive trend due to the rise in prices of petroleum products and food products in the short run and the positive output gap in the longer run. As for financial conditions, the environment for corporate finance has been accommodative. In the CP and corporate bond markets, the issuing environment has been favorable as a whole, although issuance spreads on those issued by firms with low credit ratings have expanded slightly. The lending attitudes of private banks have continued to be accommodative. Under these circumstances, the amount outstanding of lending by private banks has been increasing moderately, and the amount outstanding of CP and corporate bonds issued has been above the previous year's level. II. Conduct of monetary policy Regarding the conduct of monetary policy, the Bank's basic thinking has been that (1) given the extremely accommodative financial conditions, the level of interest rates is to be raised if Japan's economy is to follow a path of sustainable growth under price stability, and (2) the pace of increase in interest rates should be determined in accordance with improvements in the economic and price situation without any predetermined view. The Bank will continue to conduct appropriate monetary policy while confirming that Japan's economy remains likely to follow a path of sustainable growth under price stability by monitoring economic activity and prices as well as the situation of financial markets at home and abroad and thoroughly assessing relevant upside and downside risk factors. III. Disposal of stocks purchased from financial institutions Although it was not a monetary policy measure, the Bank implemented a stock purchasing program between November 2002 and September 2004. Through this program, the Bank purchased stocks held by financial institutions in order to encourage them to reduce their market risks associated with stockholdings. The Bank has started to dispose of these stocks in the market from October 2007, and the book value of the remaining stocks held by the Bank was approximately 1.5 trillion yen as of the end of December 2007. In disposing of them, the Bank has been extremely careful to avoid any financial losses and also to minimize the impact on the stock market by carefully spreading its sales out over time.
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Summary of a speech given by Toshihiko Fukui, Governor of the Bank of Japan, at the Center for Financial Industry Information Systems, Tokyo, 30 November 2007
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Toshihiko Fukui: Toward strengthening competitiveness of Japan's financial system Summary of a speech given by Toshihiko Fukui, Governor of the Bank of Japan, at the Center for Financial Industry Information Systems, Tokyo, 30 November 2007. * * * Introduction I am deeply honored to be given the opportunity to speak before many distinguished guests in the financial sector on the theme of strengthening the competitiveness of Japan's financial system. The financial system and financial markets not only allocate funds from the overfunded sector to the underfunded sector but also they sort out firms with high profitability and growth potential. The efficient and competitive financial system and financial markets are therefore vital to a country's economic growth. First I will explain the changes surrounding Japan's financial institutions, and then assess their competitiveness and profitability. I will then address the steps toward strengthening their competitiveness. Finally I will touch upon the lessons learned from the subprime mortgage problems. 1. Changes in the environment surrounding financial institutions Changes in firm activity Since the 1990s, the world economy and financial markets have undergone substantial changes. Behind that are various factors, among which globalization and information technology (IT) innovation are particularly important. The economic globalization has enabled diverse goods and services to move across the border, thereby enhanced the division of labor between the countries and the convergence of prices and wages. Advances in IT raised the efficiency of information processing and communication at a remarkable pace, which in turn eased time and geographical constraints, and led to a large cutback on the cost of remote business transactions. Against such a background, notable changes emerged in firms' international activities. Firms have been relocating their production sites overseas at a faster pace and global M&A activity has been actively taking place. Accordingly, the division of labor between the firms has also progressed. For example, in the area of software development and data processing, outsourcing has been taking place across the border. More recently, an open source approach - i.e. releasing an idea for new products and inviting other firms which are in the possession of competitive technology for possible joint production - has gained popularity. Arguably, the global IT network has underpinned the information flows behind the abovementioned processes. Changes in financial activity With the remarkable changes in firm activities, financial transactions have also gone through significant changes. First, in terms of financial instruments, the derivatives market has grown considerably with the help of finance theory and IT development. Transactions have expanded at a rapid pace: not only those dealing with assets such as government bonds and foreign exchange whose market prices are readily available, but also those dealing with credit risk whose price is derived from theoretical models. With regard to M&A finance and real estate finance, a new financial approach that attaches greater importance to cash flow has been widely accepted. In addition, progress in the securitization method has created a variety of securitized products. Second, in terms of market participants, now many types of investors are playing the market. Most notably, hedge funds and private equity funds have begun to play an important role in the global financial system. Such funds' strong demand for investment opportunities appears to have been the driving force in creating a variety of investment products including real estate financing and M&A activity. Due to such development of financial transactions and an increasing prominence of various investment funds, risk money with a diverse risk appetite is racing around the global financial markets. The current subprime mortgage problems clearly indicate that this is an era where the risks in a certain sector of a country will be distributed and be held widely by financial institutions and investors worldwide. Changes in financial institutions' business model Under such circumstances, the business model for developed countries' financial institutions, which form the centerpiece of the global financial system, has gone through substantial changes. In particular, innovative financial institutions in Europe and in the United States have increasingly relied on the so-called "originate and distribute" business model, where credit risk inherent in lending is transferred to investors via securitization. Such an increase in securitization business stems from the fact that it has become difficult to generate profits from the traditional wholesale transactions such as lending to large firms in light of the development of capital markets. In addition, it reflects a diversified risk appetite of various investment funds. Against such a background, financial institutions overseas are striving to gain higher returns on capital, taking account of stockholders' demand while securing enough capital to maintain high credit ratings. Financial institutions in Japan Japan has been making efforts to overcome the nonperforming loan problem for more than ten years since the 1990s. Financial institutions disposed of nonperforming loans, streamlined the workforce, closed down domestic and overseas branches, postponed IT investment, and refrained from strategically allocating new management resources. Such efforts paid off. Around 2005, the nonperforming loan problem was largely cleared up. Since then, they have been stepping up their efforts into more forward-looking resource allocation such as recruiting new employees, investing in new businesses and re-expanding their overseas sections. Meanwhile, the last ten years also witnessed the structure of Japan's economy and its financial system facing major changes, due to globalization and IT innovation. For example, Japanese firms including medium sized firms have been actively expanding their business overseas, and the number of M&As involving Japanese firms has been on the rise. While the corporate sector, on the whole, has become the overfunded sector, the savings rate of the household sector has been on a downward trend, due to the declining birthrate and the aging population. Therefore, it is uncertain whether the traditional financial intermediation collecting funds from the household sector and lending them to the corporate sector - will provide plenty of profit opportunity. Moreover, the easing of regulations has allowed nonfinancial industries to enter financial businesses. It is good news that Japan's financial institutions are sound again and are able to once again implement a forward looking strategy, and I commend the efforts of those concerned. Nevertheless, it should be noted that the circumstances and conditions facing competition have changed drastically during those periods, and the business strategies need to be refined accordingly. 2. Profitability of financial institutions in Japan Competitiveness of financial institutions One may ask what is the best way to gauge the ability of financial institutions to add values, when the financial sector's competitiveness is assessed with the amount of added value stemming from financial transactions. Added value means creating value that exceeds the investment cost and it cannot be assessed simply by comparing the quantity of funds and the size of assets. It needs to be assessed in light of profitability. In this regard, highly profitable banks can be seen as those that have gained support of many customers, who are satisfied with the products and services as well as the banks' pricing strategy. I now go on to review the profitability of financial institutions in Japan and discuss how to enhance their profitability. The current assessment of profitability In fiscal 2005, both major banks and regional banks posted an all time high net profit, and maintained almost the same profit level in fiscal 2006 as well. The capital adequacy rate at the end of fiscal 2006 registered 12% for major banks and 10% for regional banks. Meanwhile, out of 12 trillion yen, the amount of the public funds injected since 1998, 9 trillion yen, which accounts for three quarters of the total money injected, has already been paid back. In sum, profit and capital levels of financial institutions have been recovering significantly in recent years. Such recovery of profits has been brought about, because credit costs have been kept at extremely low levels since provisions for loan losses, which increased drastically in the process of disposing of nonperforming loans, have become no longer necessary in light of improved business conditions and progress in corporate revitalization. Indeed, net interest income and income from fees and commissions have been either decreasing or showing a sluggish growth and thus the core profitability in the banking sector has not necessarily improved. The Bank of Japan releases the Financial System Report biannually, presenting a comprehensive analysis of Japan's financial system. The latest edition released in September this year analyzed the long-term profitability of the overall banking sector (i.e. the major, the regional and the shinkin banks) since the early 1980s, and the following results came up. First, returns on assets (ROAs) were at around 0.5% even if the periods were excluded when ROAs continued to register below zero, due to large losses incurred by the disposal of nonperforming loans. Looking at the composition of ROAs, the net interest income rate and the general and administrative expense rate have been stable at around 1.3% and 1.0% respectively. That means that net asset profitability was only around 0.3%, and it could only remain positive if the credit cost was kept exceptionally low, for example, due to the reversals of allowances for loan losses. There is a risk that asset profitability will become negative, should the allowances for loan losses return to normal and credit costs rise. The low profitability of Japan's banking sector is highlighted, compared with other countries. For example, the rate of banking assets to nominal GDP in Japan is 150%, while it is only 50% in the United States. By contrast, the ROA of the U.S. banking sector has been at about 1.5% on average since the early 1980s, reaching nearly 2.0% in recent years, whereas it has been at around 0.5% in Japan, even if the years with negative ROAs are excluded from the sample. In terms of general and administrative expenses, Japan's banking sector has a considerable advantage, but the narrow interest margins from assets as well as the low non interest income ratio have been pushing down the ROAs of Japan's banking sector. In sum, while financial institutions in Japan hold more assets than its U.S. counterparts, their assets have lower added values. Moreover, contributions from profitable products and services that do not rely on the volume of assets remain meager. Factors behind the low profitability Let us now discuss why the profitability of Japan's financial sector remains low. First, as a business model, many financial institutions still rely heavily on traditional deposit taking and lending, which can be provided by any financial institution, as a source of profits. In general, it is difficult to sharpen the competitive edge of those products unless their pricing is constantly being reviewed. Moreover, while Japanese firms, having learned the lessons from the bursting of the bubble economy, have become less inclined to borrow even in the midst of favorable business conditions, bank loans still account for more than 50% of the total assets of Japan's financial institutions. With sluggish demand for loans, any attempt to increase its volume will inevitably lead to narrower profit margins. It is interesting to note that there is a clear difference between Japan and the United States when the number of financial institutions from which small and medium sized enterprises (SMEs) borrow funds are compared. In the United States, 80% of SMEs borrow funds from only one financial institution, whereas in Japan a majority of SMEs borrow from more than three financial institutions. That illustrates how severe competition is in Japan's loan market and it implies that Japan's financial institutions are yet to build mutual trust between them and their customers by offering unique customer-oriented financial services. Second, in terms of governance, it appears that most stakeholders, shareholders in particular, have been tolerant of the low profitability that has continued for a long time in Japan's banking sector. Indeed, cross-shareholdings between financial institutions and firms used to be prominent. Under such relationship, firms acted both as a shareholder and a valued customer for banks. Hence, corporate governance, in its pursuit of higher profitability, did not function well: on the one hand firms called for improvement in shareholders' value; on the other hand they pursued favorable terms and conditions on loans. Recently, crossshareholdings have dissipated and shareholdings by foreigners and investment funds, to whom maximizing shareholders' value is a priority, have been on an increasing trend. And legislative efforts to strengthen internal control are being taken. Nevertheless, looking at Japan's financial sector as a whole, initiatives that are intended to improve banks' profitability through stronger governance by shareholders and market participants as well as corporate governance within the bank still appear to be limited. Problems regarding prolonged low profitability I know other views, too. One might say that a narrow interest margin is a result of the reimbursement of profits to customers and many stakeholders are still tolerant of the low profitability. That view suggests that even if the profitability of financial institutions remains low, it may not pose a problem for the time being, and moreover that the low profitability of financial institutions may support Japan's economy through low borrowing costs. However, should the low profitability of Japan's overall financial institutions continue, it could raise concern in the following two respects. First, the future vitality of Japan's economy remains concern. The low profitability holds true not only for the financial institutions but also for many other firms in Japan. Currently, however, it is becoming increasingly difficult for businesses that only provide low valueadded products and services to survive in the global economy. For a country's economic development, the sectors with high productivity and potential for growth need to play an active role. And it is essential that risk money is channeled to such sectors without hindrance, and for that purpose, the limited resources on the part of financial intermediaries should be allocated efficiently and concentrated in the areas with highly added value. Therefore, if financial institutions do not reinforce the provision of higher value-added financial services and support firms exploring new business opportunities, the economy's future may look grim. Of course, while active overseas financial institutions could play a complementary role in reinforcing the intermediary function, they might not be able to participate aggressively in areas such as SME financing where the extent of disclosure is relatively limited. Second, securing Japan's financial stability over a longer period also is an issue. Periodical earnings are the fundamental source of strengthening a bank's capital base. Raising additional funds from the capital market is, of course, an option, but such funding can be done only if the profitability and the potential of the business are attractive to investors. Therefore, should the low profitability continue, there may not be sufficient capital in the medium to the long term to counter an increase in credit costs in case of an economic downturn, and accordingly the stability of the financial system may be put in jeopardy. 3. Measures to enhance the profitability of financial institutions Enhancing the profitability of financial institutions is particularly important in ensuring financial system stability and economic growth. Next, I discuss the measures towards enhancing profitability. Objective assessment of risk and return balances First, financial institutions should further improve the methods of assessing risk-return balances. In order to improve profitability, they must first assess the nature and the size of the risks inherent in financial products and services as well as the risks with the related asset holdings and financial transactions. Without the accurate assessment of its risk-return balances, specific action plans that contribute to enhancing profitability cannot be taken. It has been pointed out that investment banking and overseas business activities need to be reinforced at major banks, which currently have a hard time improving profitability via their domestic commercial banking business. Looking at the risk taking behavior of major banks from the perspective of integrated risk management, both credit risk and the risks associated with long-term stockholdings have increased. As such, overall risks including interest rate risk and operational risk are already reaching an amount equivalent to their core capital. That is, most of the core capital has already been used to cover the risks associated with the current financial products and services. Therefore, be it investment banking or overseas business activities, banks need to scrape together capital by assessing the current operations' risk-return balances and scale down those with low risk-return balances in order to explore new risk taking opportunities through new business operations with a higher additional value. Efforts are being made among major banks where the so-called "credit portfolio management" is used to reduce concentrated credit exposure, enhancing the efficiency of loan portfolios. Further efforts on this front to improve returns are called for. Regional banks allegedly have a mission to provide long-term support to regional customers' economic activity. For example, one might say that in dealing with a regional customer, a long term business relationship is more important than short term profits and the bank has to give support to the firm which might face a temporary downturn of its business. If regional banks are to take the risks associated with long term commitment to their respective regions, it is essential that they have the capability to assess such risks. For example, if the duration of loans to a local firm has become long, then it is necessary to quantify the risk by taking account of the period of loans extended. Moreover, if part of the loan is constantly rolled over, its associated risk should be treated in line with the risk of equity investments. Once the risks associated with regional commitment are assessed, there is a possibility that the amount of risks increases. Under such circumstances, it is necessary to secure corresponding capital. Many regional banks have already built up capital well exceeding the amount of risks they have calculated. That may suggest that those banks have implicitly prepared for the risks associated with regional commitment. However, if the risks remain vague, the improvement in returns cannot be hoped for. Clear recognition of the risks associated with regional commitment would in turn allow regional banks to take measures with respect to returns. For example, to the firms with poor business performance, early support for business revitalization can be made, which could improve their cash flow and lead to higher net interest income for regional banks. For loans that have become "pseudocapital", regional banks can act as an intermediary to invite external risk money and thus earn fee income. Selection and concentration of business operations Second, financial institutions should check whether the services they provide have a comparative advantage and need to limit the extent and to adjust the method of resource allocation accordingly. As I explained earlier, in the case of financial products and services that are commonly provided by many entities, it is difficult for the entities to pull out from unprofitable price competition. The comparative advantage of each financial product and service should be assessed, based on the non-price factors such as the ability for banks to reinforce brand potential, to offer solutions to customers, to collect non-public information, and to judge the growth potential of each product line. It is also necessary to check whether the combination of prices and the quality of financial services could be refined and moreover to address the most appropriate channel for providing such services. Having done that, financial institutions need to draw the line between the operations where more resources should be allocated and those that should be scaled down or should be done with higher efficiency. They then need to come up with a specific action plan to carry out such management decisions. It is not easy to specify the business areas that have a big comparative advantage since different financial institutions face different business environments and have different characteristics. In general, however, it is effective to explore the possibility of the added value by focusing on the nature of management resources. For major banks, for example, comparative advantages may arguably lie in a wide branch network, a large network of payment and settlement systems, a solid customer base centering on large firms, the diversity of affiliate companies and personnel, the strength to build large portfolios with diversified risks, and its business strength in the Asian region. In response to various needs such as overseas business activities of firms including M&A, demand for new risk hedge measures, the utilization of intellectual property, and product development according to various life stages of the household sector, each bank should seek the areas of great advantage. Providing adequate products and solutions to satisfy such needs, banks will secure profits for themselves as well. Also banks are expected to bridge the gap between the investment needs of domestic investors and the growth challenges faced by Asian firms. There is, however, a limit to banks' capital, and in conducting overseas operations, market participants will scrutinize credit ratings and ROEs. Banks therefore need to further streamline the areas that do not have a comparative advantage while strengthening those with greater advantages. Part of the risks should be taken by banks themselves but it is also important to accommodate various types of domestic and overseas risk money. As for regional banks, most of the customers are small and medium sized firms. Lending to SMEs which provide little information and have limited capability to pledge collateral would be a difficult business task for banks. It is hard to assess the creditworthiness and potential of SMEs through financial disclosures alone, and thus the ability to obtain unpublicized information -- such as firms' actual business conditions and the qualities of the managements -- is all the more important. In that respect, regional financial institutions have an advantage in that they could make daily and close contact with regional customers. For example, information on the blueprint of new businesses top executives draw up, concern over financial and accounting matters, successor related issues, can be obtained through a close liaison while having acute awareness of a business opportunity. Such information might lead to increased profitability of the regional financial institutions if they could make a proposal to improve such firms' cash flow with whatever special skills they have. It is also important to share, and not to store away, such "live" information within the organization and to construct a database that enables concerned parties to use the information from various perspectives. It requires certain costs to maintain a framework that collects non-disclosed information based on close contact with customers and therefore, measures to further enhance the efficiency need to be taken, such as the use of outsourcing, with respect to the number and the distribution method of products and services with a small competitive advantage. Merits and pitfalls of mergers and consolidations So far, I have described that general financial services offered by a number of financial institutions are difficult to differentiate and that it does not necessarily lead to enhanced profitability. One might argue that the profitability of such businesses could be enhanced by mergers and consolidations of financial institutions. Economic theory shows that the scale economy can take place and indeed some empirical analysis confirms that the efficiency of general and administrative expenses could be improved, while another analysis suggests that a mere increase in asset size would push down lending rates, offsetting the improvement in general and administrative expenses. Since many analyses on mergers and integrations cover the period when financial institutions struggled with the non performing loan problem, the picture may turn out to be different when financial institutions engage in M&A activity as part of a forward-looking business strategy. As I mentioned in the beginning, various types of M&As are currently taking place in the non-financial industries. Japan's financial industry will naturally engage in M&A activities in their pursuit of raising their corporate value. For example, acquiring business operations that bring a greater synergy with the current operations, or selling business operations with a small competitive advantage are a few means of enhancing their corporate value. With respect to cross-border M&As, the recent revision of Japanese corporate law enabled overseas firms to conduct a forward triangular merger through the exchange of shares. In fact, the first case took place in the financial industry, where a large U.S. banking group acquired a major securities firm in Japan. In summary, while mergers and integrations that simply increase the asset size do not necessarily lead to enhanced profitability, M&As could be an effective tool for improving profitability if they are used to strengthen and streamline business operations that have a comparative advantage. Measures for legal and accounting infrastructure So far I have outlined the measures taken and challenges faced by financial institutions themselves. Improvement in its infrastructure is also imperative in enhancing the profitability and competitiveness of Japan's financial system. Now I mention a few issues that require improvement with respect to legal and accounting infrastructure. First, the transparency and reliability of financial accounting information should be enhanced. In order for financial institutions and investors alike to adequately assess the risks when extending credit or making an investment decision, further disclosure of firms' financial information is necessary. In that respect, the Financial Instruments and Exchange Law enacted in September 2007 introduced mandatory quarterly releases of financial information to listed companies. And to secure the reliability of the released information, the law obliges companies to submit certification of an annual report and an internal control report. Still for SMEs the scope of financial statements subject to external auditing is relatively limited in Japan, compared with other countries and further improvement in raising the reliability of disclosed information is called for. Second, the reform of Japan's financial system should enable financial institutions to provide flexible financial services in response to diversified needs of the corporate and household sectors. More specifically, consideration should be given to easing the firewall regulations between banking and securities business, which are somewhat stricter than other developed countries. From the financial institutions' perspective, that has an effect of facilitating more synergy within a financial group. The major premise behind such regulation easing is to ensure that prevention rules of unfair transactions such as prohibition of insider trading and rules to protect retail investors be firmly put in place. Third, the reform of the public financial sector should be carried out without delay. Japan Post has already begun its business and preparations for integrating public sector financial institutions are currently underway. Financial institutions due to be privatized are to build robust risk management and operational systems and are expected to take part in a sound and fair competition with other private financial institutions. As for government sponsored financial institutions fulfilling government policy objectives, if the areas of overlap with private entities are large, it may prevent private financial institutions from adjusting risk-return balances. The operations of public institutions should be based on the principle that they are complementary to the private sector. Consideration from overall economy So far, I have talked about the measures taken by financial institutions and the reform strategy of the financial system towards enhancing the profitability of financial institutions. However, low profitability relative to asset size and capital is also applicable to many Japanese firms with the exception of large firms facing severe competition in the global market. In terms of risk taking towards new businesses, the amount of cash and deposit against the total asset outstanding in Japan's manufacturing industry is two times as high as that of the U.S. counterpart. That may suggest that Japanese companies are more cautious about taking new business risks. Put it another way, if companies hold excess liquidity at hand against future investment opportunities, that may suggest that financial services intending to provide funding in a flexible manner are not functioning well. For the future of Japan's economy, it is essential that both the ability of firms to take new risks in creating higher value-added products and the capacity of financial institutions to provide risk money and business solutions should develop hand in hand together. Fortunately, Japan has the manufacturing industry with strong international competitiveness and moreover it has the world's largest accumulation of financial assets. The IT infrastructure such as high-speed telecommunications wire networks is as much developed as in Europe and the United States. It is strongly hoped that both the industrial sector and the financial sector, taking advantage of their comparative superiority both in stock and flow measures, create further added values through technology and knowledge in order to vitalize Japan's economy. 4. Closing remarks In closing, let me give a few remarks on the recent turbulence in global financial markets triggered by the subprime mortgage problems. As the subprime mortgage problems have worsened and spread more widely in financial markets abroad, the impact on Japan's financial institutions has been felt at a pace faster than expected. For instance, some financial institutions registered losses as a result of a decline in the market value of investment products, and others posted losses from revaluation on the unsold products arranged as part of their securitization businesses overseas. However, since Japan's financial institutions' exposure to the U.S. credit markets is relatively low, it appears that so far each financial institution/group has been able to absorb the losses within its annual earnings or its capital base. While further developments in the U.S. and European financial markets need to be monitored closely, it seems unlikely that this particular problem will pose a significant threat to the stability of Japan's financial system. Based on the experience pertaining to the subprime mortgage problems, several lessons could be drawn for the management of financial institutions and the functioning of financial markets. And two lessons seem particularly noteworthy. The first lesson stems from the difficulty of both transferring and disconnecting the risks from financial institutions. Subprime mortgage loans are, indeed, riskier than normal housing loans, and most of the risk was believed to be transferred from financial institutions to investors via securitization. The outbreak of the subprime mortgage problem made it clear that risks in fact manifested themselves among financial institutions in a variety of forms. As it became increasingly difficult for financial institutions to resell securitized products to investors, they were forced to carry an unexpected inventory of such products. When the market liquidity dried up, they had to post a vast amount of losses as well as valuation losses. Since investment funds with a large amount of securitized product investments found it difficult to raise short term funds from the market, some financial institutions --whether they set commitment lines or not-- provided a substantial amount of liquidity. Those incidents indicate that in an era of highly distributed risks and well diversified financial intermediation, financial institutions are involved in risk intermediation in various forms and they sometimes have to face unexpected risks once a large shock hits the market. Based on that experience, financial institutions and those engaged in securitization businesses need to improve risk management practices, such as revising the valuation model of securitized products and developing an evaluation model of market liquidity risk. In addition, it seems that the "originate and distribute" type of business model still requires further improvement. Second, it is important to enhance transparency when developing new financial technologies and products. In particular, when a great financial shock occurs, concern spreads over the entire market, and it is likely to provoke an excessive response. Ten years ago, during the Asian currency crisis, criticism was leveled at the opaqueness of hedge funds in terms of their investment strategy and scale. As for the current subprime mortgage problem, concern over the difficulty in identifying the location of risks has risen since they have been dispersed worldwide through securitization. All in all, it should be noted that risk transfer transactions such as securitization and credit derivatives have indeed the function to stabilize the financial system through diversifying risks. Various innovative activities including the development of highly sophisticated financial technology should never be hindered, and the fruits of such activities should be used for the purpose of stabilizing and developing the global economy. Toward that end, it is of utmost importance that financial institutions and relevant parties that endeavor to build a new market using the state-of-the-art technology revise the transaction rules and practices and disclose information on a voluntary basis. With respect to regulation and supervision, the framework needs to be designed in view of encouraging private financial institutions to create a new added value and accordingly to promote sophisticated risk management. In any case, the issue faced by Japan's financial system remains to be the overconcentration of risks in the banking sector and it is still being addressed. The low profitability of the banking sector may be a reflection of such a problem, and it is important for Japan's financial institutions to further hone risk management skills and enhance the value-added financial services and profitability. And while it is an ironclad rule "not to invest in the products with obscure riskiness", it is necessary to improve the ability to assess the complex nature of risks and to make efforts to provide higher value-added financial services. Such prudence and continued efforts towards innovation will contribute to maintaining the stability of Japan's financial system and to enhancing its competitiveness. The Bank of Japan will continue to support such efforts to enhance risk management and to create additional values of financial services through on-site examination, off-site monitoring and seminar activities. Thank you for your attention.
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Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the Kisaragi-kai Meeting, Tokyo, 22 February 2008.
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Toshihiko Fukui: The Japanese and world economies – looking to the future Summary of a speech by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the Kisaragi-kai Meeting, Tokyo, 22 February 2008. * * * Introduction Today, I will begin by discussing recent developments in the economy and financial markets as well as the thinking behind the Bank of Japan's conduct of monetary policy. I would then like to turn to the medium- to long-term issues facing the Japanese and world economies, and to present my ideas on how to address them. I. A. The current situation and the outlook for Japan's economy Developments in overseas economies Let me first touch upon recent developments in global financial markets and overseas economies, as a premise to considering the outlook for Japan's economy. Global financial markets have been unstable due mainly to the downgrading of securitized products and heightened concern about possible further losses at financial institutions stemming from the U.S. subprime mortgage problems. Toward the end of 2007, money markets in the United States and Europe came under pressure from financial institutions' eagerness to secure year-end funds, and this caused interest rates on term instruments to surge. To address this situation, from the middle of December onward, central banks in the major economies coordinated their implementation of responsive measures such as liquidity provision. As a result, interest rates on term instruments have fallen and money markets are recovering their stability. On the other hand, the functioning of markets for securitized products, where the problem originated, remains impaired, and stock markets and foreign exchange markets have been volatile globally. Investor risk-aversion persists, and projected losses at financial institutions in the United States and Europe are greater than initially expected. Although financial institutions in these countries have successively announced measures to boost their capital, underwritten with investment from, among others, sovereign wealth funds from emerging economies and oil producing countries, market participants remain circumspect, keeping a weather eye on future disclosures of losses at financial institutions and their measures to compensate for these losses. The world economy continues to expand as a whole, but the uncertainty regarding its future path is increasing due to the aforementioned volatility in global financial markets. In the United States, an economic slowdown is becoming more evident. Housing investment is down substantially, with the fall in housing sales and the rise in the already-elevated stock of unsold homes continuing unabated. Home prices continue to fall, and there is no indication that the bottom has yet been reached. Moreover, recently released information suggests that employment and production have weakened somewhat and that banks are tightening lending standards not only for housing loans but also for commercial real estate loans, as well as loans to both businesses and consumers. A slowing of the pace of increase in private consumption is becoming somewhat more evident, but the trend remains moderately upward. Business fixed investment, meanwhile, is also continuing its moderate upward trend. In terms of macroeconomic measures to address the situation, the Federal Reserve has been aggressively lowering its policy interest rate, and the U.S. government has decided on a fiscal package to stimulate the economy, including a tax reduction. Although lower growth in the U.S. economy may be unavoidable for the time being, it is likely to return to a path of growth close to potential, as the housing market correction draws to an end, the tightness in financial conditions eases, and the effects of policy measures make themselves felt. The risk should, however, be borne in mind that, if the negative effects from the housing market correction or financial market developments are greater than expected, the U.S. economy may slow further through negative wealth effects, credit tightening, and deterioration in business and consumer sentiment. The euro area economy continues to expand, though the pace of increase is moderating. Although export growth has recently decelerated and there are causes for concern, such as weakness in indicators of private consumption and volatility in financial markets, activity in the corporate sector, particularly business fixed investment, remains strong and it is likely that economic growth will continue. As for other regions, growth continues to be robust, especially in China, India, and Russia, while the NIEs and ASEAN economies are also maintaining a moderate pace of expansion overall. Thus, the world economy taken as a whole is continuing to expand. However, we need to bear in mind the possibility that, depending on their extent, future disruptions in global financial markets or a slowdown in the U.S. economy may have adverse implications not only for major economies but also for emerging economies. At the same time, attention should also be paid to the risk of inflation. In the United States and Europe, consumer prices are continuing to rise due to increased energy and food prices. In China, there are signs of overheating, visible especially in fixed investment, and inflation is rising, with food prices increasing at a faster pace. Meanwhile, given the high prices of grains such as wheat and soybeans as well as of crude oil and gold, possible shifts in international commodity prices may also influence the outlook for the global economy and the price situation. At the G-7 Financial Ministers' and Central Bank Governors' meeting held recently, the aforementioned assessment of economic and global financial market conditions was generally agreed. Moreover, participants reaffirmed that they would address their domestic concerns within a cooperative framework so as to realize financial market stability and sustainable growth on a global basis. B. The current situation and the outlook for the Japanese economy As for Japan's economy, we expect that, although the pace of growth may remain slow for a while, the economy is likely to continue its sustained expansion under conditions of price stability since the virtuous circle of growth in production, income, and spending will remain basically intact. Careful attention, however, should be paid to risk factors such as the aforementioned developments in overseas economies and global financial markets as well as the effects of high energy and materials prices. In the corporate sector, business sentiment is characterized by caution, because of the following factors. First, the revised Building Standard Law, which came into force in June last year, has been pushing down housing investment significantly. Second, the elevated prices of materials such as crude oil have been reducing profits, especially at small firms. And third, the subprime mortgage problems have been generating increased uncertainty about the future course of the world economy. However, since overseas economies as a whole continue to expand, exports to a broad range of regions, including emerging economies and oil producing countries, are increasing and their overall trend remains upward. In this situation, production to date has continued to increase. Looking forward, however, production is expected to remain flat for a while, mainly because the accelerated production of automobiles to make up for the disruption caused by the Niigata-ken Chuetsu-oki Earthquake in July 2007 is coming to an end. Nevertheless, production is likely to resume its upward momentum, given that levels of inventories and shipments are essentially well in balance. Business fixed investment is also likely to follow an uptrend, as firms are not under pressure to adjust production capacity or employment. Let me now turn to developments in the household sector. Nominal wages per worker have been somewhat weak, but moderate growth in employee income is continuing, supported by an increase in the number of employees. The gradual increase in employee income is likely to continue, as it is expected that firms will continue to experience labor shortages and corporate profits will remain generally high. In this situation, private consumption is expected to follow a gradual uptrend. However, as prices of daily necessities such as food and gasoline have been rising recently, consumer sentiment appears to have deteriorated, and this may have adverse consequences to which attention will need to be paid. Meanwhile, housing investment, which has been suffering significant declines as a result of procedural changes accompanying the enforcement of the revised Building Standard Law, is nevertheless expected to recover gradually as the delays in the confirmation of building applications are resolved. In fact, the number of housing starts has already been showing signs of recovery. The pace of recovery, however, is still uncertain, since sales of condominiums, whose prices are rising, remain relatively weak. Regarding prices, the domestic corporate goods price index (CGPI) has been rising mainly due to higher international commodity prices. The year-on-year rate of change in the consumer price index (CPI, excluding fresh food) posted a 0.8 percent increase in December due mainly to rises in the prices of petroleum products and food products. This positive trend in the rate of change is expected to continue: in the short run, due to the effects of high prices of petroleum products and food products; while in the longer run, because supply and demand conditions in the overall economy are expected to tighten as the moderate economic expansion continues. C. Future conduct of monetary policy I would now like to explain the Bank's thinking regarding the conduct of monetary policy based on the outlook for economic activity and prices and risk factors I have described. In conducting monetary policy, it is important not to be swayed too much by short-term developments but to make forward-looking projections of economic and price trends. As I noted earlier, the growth of Japan's economy, for the time being, seems likely to decelerate while prices continue to rise, although, looking forward, the economy is likely to resume a moderate expansion under conditions of price stability. Given this, our basic stance on the future conduct of monetary policy remains unchanged. We will continue to carefully assess the levels of uncertainty associated with the projected future paths of the economy and prices and to remain attentive to both upside and downside risks, thereby ensuring the appropriate conduct of monetary policy. II. The Japanese and world economies over the medium to long term: issues and strategic direction I would now like to discuss medium- to long-term issues facing the Japanese and world economies and what steps should be taken to address them. The key word is "sustainability." In other words, we need to consider what we should do to achieve sustainable growth. A. Issues facing the world economy and basic ideas to address them 1. Structural issues affecting the world economy Various problems the world economy is facing today, such as the substantial rises in crude oil and food prices, global imbalances, and the turmoil in global financial markets, should be understood in the broader context of changes that have taken place since the 1990s – specifically, the rapid ascendance of emerging economies, the progress of economic globalization, and the globalization and increased sophistication of financial markets. From the latter half of the 1980s, emerging economies began, one after another, to adopt market economic systems, and since the 1990s they have been rapidly increasing their presence in the global economy. For several years at the beginning of the new century, this was a factor contributing to the benign global economic and financial environment. The world economy was able to enjoy a period of unusually high growth driven by economic expansion in these emerging economies. On the price front, their abundant labor force brought about a dramatic increase in the global supply of products along with an accompanying price decline. In addition, efforts by central banks to stabilize prices allowed the situation of low inflation to continue. During the resultant period of stable prices, the financial environment was kept accommodative. The generous inflow of funds from emerging economies and oil producing countries to leading economies such as the United States also acted to facilitate the continuation of the accommodative financial conditions. It was against this background that rapid advances in financial technology were made. This benign situation, which could be characterized as "high growth," "stable prices," and "financial accommodation," lasted for a long period in the early 2000s. However, the reverse side of this seemingly benign structural situation has emerged gradually. In many rapidly growing emerging economies energy efficiency is low, and this has increased demand for resources such as crude oil. Coupled with concerns over the possible disruptions of supply, this has led to sharp rises in the prices of international commodities. In addition, increased demand for food, as living standards among workers in emerging economies have improved, has combined with a growing interest in alternative energy to generate substantial rises in prices of foods such as grains. Given resource constraints, questions have begun to emerge as to whether the current robust growth led by emerging economies is sustainable in its present form. Meanwhile, in financial markets, the benign economic and financial environment had allowed market participants to become lax in their risk evaluation and resulted in some extreme positions being taken. Consequently, last summer saw the subprime mortgage problems inducing a large-scale reevaluation of risks in markets for securitized products, which has since spread to encompass other markets. In the past six months, various measures have been taken in response, but global financial markets remain unstable. Since what we are witnessing is a process of risk repricing within the broad structural context discussed earlier, adjustments may be expected to take some time. It is also inevitable that, during this process, financial institutions will incur losses. 2. Basic ideas to address these issues In considering what we should do to realize sustained world economic growth, it is necessary to put recent problems into their broader structural context. The ongoing globalization of the economy and financial markets, as well as advances in financial technology, cannot and should not be stopped, because they basically act to increase people's welfare through the efficient allocation of resources. Rather, in the globalized economy, it is important to ensure an environment where various markets can function fully, thus allowing resources to be allocated efficiently. Furthermore, this environment should be secured swiftly, and should not be permitted to lag behind the pace of globalization and the advance of financial technology. First, it is becoming increasingly necessary for emerging economies, in line with their growing presence in the world economy, to introduce more flexible foreign exchange systems and to improve the functioning of their financial and capital markets. Global imbalances are the result of many factors, including investment and saving behavior across different countries and the systems that determine these, with inflexible foreign exchange systems being another. In terms of the flow of funds, imbalances are maintained as the abundant funds accumulating in emerging economies and oil producing countries are invested overseas, principally in the United States. To address this problem, it is of course essential that the economies concerned take measures to improve the balance of their investment and saving. At the same time, allowing market mechanisms to operate under more flexible foreign exchange systems will contribute to the balanced and sustained growth of the world economy. A related problem is that improvements in the functioning of financial and capital markets in emerging economies are not keeping up with the pace of globalization. Progress in this area will contribute to stable economic development in these economies by strengthening their ability to withstand disruptions in the flow of funds, as well as further enhancing the efficiency of the allocation of funds on a global basis. As an example of efforts in this respect, the Bank of Japan, with the cooperation of other central banks in Asia, is promoting a program called the Asian Bond Fund to nurture bond markets in Asia. Second, areas can be pointed out where the rapid pace of progress in financial innovation may not necessarily have resulted in the improved functioning of financial markets. The recent turmoil in global financial markets triggered by the subprime mortgage problems has highlighted this point. Despite the involvement of technologically advanced financial institutions and credit rating agencies applying cutting-edge financial theory at every stage of the process from the original disbursement of housing loans to their securitization and sale to investors, the end result was still large-scale losses. The task now is to analyze why market mechanisms failed to achieve the appropriate risk evaluation and pricing, and how the framework can be reconstructed so as to ensure that the incentives to do so operate properly in the future. Various parties, including the authorities, should consider what they can do to help achieve this; yet, needless to say, the primary role must be played by market participants themselves. It is in market participants' own interest to strike a proper balance between risk and return, and ensuring that this intrinsic incentive is allowed to operate is fundamental to any reconstructive efforts. At the recent G-7 meeting, the interim report submitted by the Financial Stability Forum working group toward the construction of such a properly incentivized framework was discussed, and its final report is scheduled to be submitted at the next meeting in April. Third, the issue of energy and resource conservation is important not only in environmental terms but also as the basis for realizing sustainable world economic growth. To be more specific, it is necessary to raise the energy efficiency of countries where efficiency rates are low and for resource producing countries to ensure that systems of supply are stable. We must think how this could be achieved under market mechanisms and how externalities, such as the global-scale environmental problem posed by CO2 emissions, could be addressed. Improving energy efficiency and developing cleaner energy are areas that should benefit from technological expertise found in the private sector. Although individual countries have been trying to provide the proper incentives to achieve these ends, it should not be forgotten that this is a global issue, and one which would benefit from the application of market mechanisms. For example, a market for emission rights would not only allow the appropriate valuation of emissions costs but would also provide market incentives for the development of advanced technologies to increase energy efficiency. There are, of course, other problems that need to be addressed, yet in terms of broad strategic direction, the response is qualitatively the same: rapid changes in the social and economic environment, such as globalization, should be dealt with by making appropriate use of market mechanisms, while adjusting the existing infrastructure as much as necessary. Such an approach will establish a basis for sustained world economic growth while avoiding the pitfalls of protectionism. B. Issues facing the Japanese economy and basic ideas to address them 1. Demographic change: population aging and the declining birth rate I will now turn to the medium- to long-term issues facing Japan's economy. The most significant of these in terms of achieving sustained economic growth is the progress of demographic change, specifically the decline in the birth rate and aging of the population. Faced with such demographics, we need to ask ourselves how Japan can make use of global vitality to boost its own economic strength. The sources of economic growth are labor input and accumulated capital. Using these efficiently to enhance value added, in other words, to increase productivity, is what generates economic growth. Looking first at the labor situation, the size of the labor force may be expected to decline along with the decrease in the working-age population. To curb this decline, the labor force participation rates of the elderly and women need to be raised. This in turn requires the provision of a better working environment for potential workers in these categories. Second, to accumulate capital, Japanese firms need to remain an attractive target for domestic and overseas investors. The funds that flowed out of U.S. securities markets due to the subprime mortgage problems did not necessarily head for Japan. Given that Japanese firms are world leaders in terms of their technological prowess, there is no reason for overseas investors to form an unfavorable evaluation of their profitability or other such measures of their corporate strength. What seems needed, therefore, to attract inward investment into Japanese firms is to improve areas such as corporate governance and financing, consolidating the environment and infrastructure of capital markets to facilitate easy access by investors both at home and abroad. Achieving this will require a painstaking process of constant review and response. Third, in order to increase productivity, it is necessary to move forward with institutional changes, including deregulation, so that the private sector may be able to perform to its fullest potential. To be competitive in the global economy, trading arrangements, such as free trade agreements, are important. Yet, it is also important to ensure that infrastructural arrangements, such as adequate protection of intellectual property rights to facilitate the accumulation of advanced technologies and knowledge, are continually refined and updated to accommodate the most recent changes. In the nonmanufacturing sector, in particular, it is important to accumulate knowledge and enhance the innovative potential of Japan as a whole. For this purpose, measures that take advantage of the dynamism of globalization, such as measures to attract the most talented minds from abroad, which have been introduced in other countries to strengthen their international competitiveness, should be pushed forward. Even assuming that these necessary efforts are steadily pursued, we must still bear in mind that the issue of the declining birth rate and aging population cannot be conceived from a purely economic standpoint. Even if various incentives are put in place and the necessary infrastructure of day care facilities and so on are provided in an attempt to curb the declining birth rate, ultimately the problem remains one of personal choice. Similarly, the issue of immigration, which is often proposed as a more direct means of addressing the labor shortage, is a matter of public choice that involves not only economic but various social considerations. A major reason for Japan's low potential growth rate relative to the United States and European countries lies in the fact that it expects fewer immigrants and this is reflected in a lower expected increase in its working population. One way to raise Japan's potential growth rate is evidently to ease restrictions on immigration. I think the time has come for us to think very seriously about whether we should accept more immigrants, or whether we would prefer to remain a relatively homogeneous society and be satisfied with low economic growth. It seems increasingly necessary for Japan to decide how it wants to fit in to the global economy. 2. Fiscal consolidation Closely related to the problem of the declining labor force is another medium- to long-term issue, the consolidation of the fiscal situation. It scarcely needs repeating that Japan's public finances are in a severe situation. What is crucial here, however, is that the problem is a medium- to long-term one to which measures with only short-term effects will not provide a viable solution; moreover, dealing with the problem will require reconsidering the income distribution. As the nation's demographics continue to shift, the number of retirees will inevitably increase relative to the size of the working population. From a public finance perspective, the implication is that the number of those who bear the burden of public finances in the form of taxes will decrease while the number of those who benefit from public finances in the form of social security payments will increase. If the income distribution remains the same – in other words, if relative shares of the total pie are not altered – the public finances will deteriorate further. Reforming these will inevitably entail some pain. However, in the end there is no choice but to construct a sustainable new system, and if the public can be convinced of the system's sustainability, then it will go some way to dissipating their anxiety about the future. To ease the process of reallocating shares of the pie, it is important to increase the economic growth rate. With a larger pie, it becomes possible to adjust income distribution without requiring social security beneficiaries to give up such a large amount in absolute terms. What is important is that the pie must become larger in real terms; in other words, real growth must rise. Higher inflation alone will not produce the desired effect if the real growth rate does not rise. A rise in the inflation rate without a change in the nominal size of pensions simply translates into a decrease in the real value of pensions. Neither does higher inflation represent a quick fix for the public finances. A rise in the inflation rate would indeed result in increased tax revenues, but expenditure would also increase, as would interest payments on government bonds, which would rise in line with higher interest rates. In short, there are no quick fixes or free lunches when it comes to reconstructing the public finances. Constructing a sustainable system of public finances and social security may be painful, but it is the only certain route to travel, and it will require facing up to two necessities: first, in response to the declining birth rate and aging of the population, there must be some kind of change in the income distribution between generations; and second, this process of changing the income distribution can only be accomplished smoothly if real economic growth and economic strength are increased. The actual shape of the sustainable system that emerges, whether it is achieved by increasing the tax burden or by reducing public expenditure, is a matter for the public itself to determine. C. The role of central banks Lastly, I would like to discuss the role of central banks in addressing the medium- to longterm issues I have talked about. With the further evolution of economic and financial globalization, central banks should contribute to economic and price stability through the appropriate conduct of monetary policy, while also ensuring that financial markets and the financial system are both efficient and stable by providing liquidity and making sure that markets function properly. Let me start with the second of these roles, namely, ensuring the efficiency and stability of financial markets and the financial system. As has become clear during the recent turmoil in global financial markets, liquidity provision by central banks plays a significant role in stabilizing financial markets. With the increase in the volume and complexity of cross-border flows of funds, coordination among central banks in their performance of this role is essential. Behind the coordinated provision of funds by central banks in December, which I have already mentioned, there lay discussion among central banks and the attainment of a consensus about the economic situation and measures to alleviate it. I believe that the framework for liquidity provision introduced in Japan to deal with the past financial crisis has proved instructive to other countries in designing appropriate measures. In addition to their provision of liquidity to markets under normal conditions, central banks stand ready to provide funds directly to individual financial institutions as the Lender of Last Resort in cases, for example, when an institution is experiencing difficulties raising funds in the markets. Given the globalization of financial services, such cases now require closer communication among the countries involved. It is, of course, important to respond ex post to market turmoil or fund-raising difficulties at individual financial institutions; however, it is also vital to share ideas and develop appropriate systems prior to such incidents. More specifically, as the financial business becomes increasingly globalized, central banks must rigorously discuss how to ensure the international cooperation and communication needed to improve operational tools and collateral arrangements as well as to enhance the compatibility of their Lender of Last Resort and macro-prudential policies. Taking a longer-term perspective, we must also consider how each country can help improve the working of progressively globalized financial markets. Given that of the various public authorities it is central banks which are closest to financial markets, they have a correspondingly important role to play in providing a steady response to the rapid globalization and growing technological sophistication of financial markets. Next, I would like to turn to monetary policy. As globalization proceeds, assessment of the domestic economic and price situation increasingly demands that attention be paid to the influence of economic and market conditions overseas. At the same time, it has also become apparent that, since monetary policy takes effect via its influence on financial markets and the behavior of financial institutions, the globalization of financial markets means that policy actions by individual central banks are mutually influential. It is for this reason that central banks have frequent and detailed exchanges of views about each other's economic and financial situations as well as their respective thinking concerning monetary policy. The basic task of central banks, however, remains unchanged. Each central bank, having a good understanding of conditions overseas, should assess its own economic and price situation in a forward-looking manner and carry out appropriate policies to ensure that economic growth and prices remain stable. Central bankers universally agree that the stability of the world economy is achieved by economic and price stability in each country supported by appropriate monetary policy. Although the ultimate goal of monetary policy remains economic and price stability, I must add that to achieve this it is not enough to look only at price indices and growth rates. We must be attentive to factors likely to affect the economy and prices in the long run, such as developments in asset prices as well as the financial market situation and state of the financial system. Episodes such as the recent subprime mortgage problems or the bursting of the economic bubble in Japan indicate that changes in asset prices may on occasion result in considerable fluctuations in the economy and prices over the medium to long run. To achieve long-run economic and price stability, therefore, we need to be constantly vigilant concerning risk factors such as bubbles or financial system disruptions that cause large losses when they materialize, even though the probability of such materialization may be low. In this regard, information such as developments in asset prices as well as changes in market conditions and the state of financial system stability should be carefully analyzed. These points of concern are incorporated within each central bank's framework for conducting monetary policy. In the case of the Bank of Japan, we examine such long-run risk factors under the "second perspective" specified in the framework for the conduct of monetary policy introduced in March 2006. The European Central Bank (ECB) crosschecks information obtained through its assessment of the economy and prices against that obtained from its monetary analysis. The Federal Reserve, with its introduction last November of measures to enhance transparency, started to make public Federal Open Market Committee (FOMC) participants' views about the level of uncertainty and risk factors affecting its medium-term outlook. Even countries that practice inflation targeting do not automatically adjust policy rates to keep inflation within their predetermined range, but retain a degree of flexibility in meeting their targets. The Bank of Japan conducts monetary policy so as to achieve long-run economic and price stability by analyzing a wide range of information, including indicators of global economic trends and financial conditions. By ensuring economic and price stability in the medium to long term, the Bank will provide a solid foundation upon which both firms and households can formulate their plans for the future and base their actual economic behavior. I believe this will, in turn, allow us to take advantage of global economic vigor to successfully confront the issues of demographic change and fiscal consolidation. Closing remarks Today, I have talked about medium- to long-term issues facing the Japanese and world economies and I have put forward some basic strategies for addressing those issues. There are certainly a number of issues that require attention. However, I believe that the world economy has the potential for further development and that Japan's economy is well capable of succeeding in the global market. It is my firm hope that the economies of both Japan and the world will realize sustainable growth by successfully addressing each of these issues, and the Bank of Japan in cooperation with other central banks will continue to perform its supportive part in this process.
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Opening remarks by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the Nikkei Islamic Finance Symposium 2008: "Islamic Finance: Constant Evolution and Emerging Opportunities", Tokyo, 23 February 2008.
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Toshihiko Fukui: Islamic finance – developments, diversity and challenges Opening remarks by Mr Toshihiko Fukui, Governor of the Bank of Japan, at the Nikkei Islamic Finance Symposium 2008: "Islamic Finance: Constant Evolution and Emerging Opportunities", Tokyo, 23 February 2008. * * * Introduction It is a true honor and pleasure to be invited to the Nikkei Islamic Finance Symposium, and to have the opportunity to share my thoughts about Islamic finance along with Governor Zeti of Bank Negara Malaysia and distinguished guests. The Bank of Japan joined the Islamic Financial Services Board (IFSB) as an observer last year. We believe that this will help us deepen our understanding of the latest developments in Islamic finance, which has rapidly evolved and come into the spotlight of global finance. Development of Islamic finance Islamic finance has developed phenomenally in recent years. There are no precise figures that show the market size of the Islamic finance industry, but according to an estimate by the IFSB and other Islamic institutes at the end of 2005, more than 300 financial institutions in more than 65 jurisdictions manage financial assets in a Shari'ah compatible manner, which total between US$700 billion and 1 trillion. From this figure, Islamic finance represents a modest 1% of global financial assets, but its growth in recent years is notably impressive. Islamic finance related assets have continued to grow at a robust 10-15% per annum on average since the mid-90s, and are expected to maintain this speed of expansion over the next few years. Among others, Asia is one of the regions characterized by the dynamic development of Islamic finance. To give a few examples, Islamic finance products are estimated to comprise more than half of the financial services provided in the Gulf Cooperation Council region by 2015. In Malaysia, more than half of private debt securities are Islamic bonds. The credit for this must go to the leadership of Governor Zeti, who has adopted a variety of policy measures to make Malaysia an Islamic financial center. Islamic finance has a long history. As a place where the three continents of Asia, Africa and Europe meet, the Middle East has flourished as a trading center since antiquity. In those days, there were active financial transactions in funding and settlement for trade. It is said that bills and checks already circulated in the 11th century, and that the word "check" has its origin in Farsi. Islamic finance has a long-established tradition, yet, it is only rather recently that Islamic finance has developed in a global context. The recent rise takes place against the background of an increase in financial assets supported by Middle-East petrodollars and a growing number of Muslims seeking to have their assets managed under religious tenets. An equally important factor that propelled growth in Islamic finance is recent advances in financial technologies, namely, structured finance. The Islamic finance industry has been able to introduce a scheme of profit sharing instead of prohibited interest payments. This has led the way to the development of a range of financial products, including the Islamic bond, or sukuk. Islamic finance brings greater diversity The development of Islamic finance brings diversity to financial markets and financial transactions. When market players with different sets of values enter a market, they increase the variety of financial transactions, which in turn promotes financial market development and creates business opportunities. At the same time, it has a positive effect on the real economy through more efficient resource allocation. Against this backdrop, I have a keen interest in what kind of new financial services Islamic finance will provide in the future. To date, Islamic finance institutions have provided many products that replicate those of conventional finance while respecting Islamic values, where interest, or riba, is prohibited. In other words, Islamic financial institutions have successfully provided conventional intermediary functions by utilizing the latest financial technology. I look forward to seeing further developments which will enable Islamic finance to carry out new functions that conventional financial instruments can not serve. Such innovation will improve the allocation of resources, while operating in accordance with Islamic values. There are of course a variety of conventional transactions, but basically, all are a combination of two factors, risk and return. Islamic finance is expected to offer further possibilities to finance by adding a new dimension to risk and return, which is Islamic values. An example would be the development of microfinance under a framework that places great importance on Islamic values such as fairness and equality of social economy and business partnership. Islamic finance that offers a broad range of products and services is also important from the perspective of financial market and financial system stability. In principle, in a time of stress, a market with diversified participants and transactions is robust compared to a market of homogeneous participants and limited types of transactions. Since the Asian currency crisis, Asian countries have been striving to create diversity in the source of funds, including bonds, instead of relying heavily on banks. I believe that the growth of Islamic finance will also contribute to resolving these problems. Challenges ahead Islamic finance is making impressive growth and is expected to continue to do so in the years ahead. Still, there are many unknown factors in this financial sector, as new types of Islamic finance transactions have evolved relatively recently. For instance, how does arbitrage between Islamic finance transactions and conventional financial transactions take place? With greater presence in the global market, what kind of impact will Islamic finance have on the pricing mechanism in the global financial market? The size of cross-border capital flows generated from Islamic finance products is growing. How will this impact the stability of the global financial system? I have expressed my view that diversity in the market will bring about stability. However, the rapidly growing modern Islamic finance industry has never been exposed to serious stress in the global financial market. Stress tolerance can only be acquired through the experience of riding out numerous crises in the financial market and financial system. In this regard, I would like to watch closely developments in Islamic finance in the coming years. One of the potential vulnerabilities in the international financial system is the global imbalance problem. There is a huge gap between the deficit in the US current account, and the surplus in the current accounts of Asian countries and oil producing countries. The gap has been filled by the smooth flow of a significant amount of capital. In this context, understanding the flow of Islamic finance capital originating from oil money has certainly become the key when considering sustainability of the current state of the global economy. On the regulatory front, there are ongoing discussions on how to develop risk management and a regulatory framework to match the rapid expansion of the Islamic finance industry in order to maintain stability of the financial system. The key to addressing this issue would be consistency with conventional risk management and regulatory frameworks. This is a matter of great importance for the coexistence of the Islamic financial system with conventional financial markets and systems, and for providing beneficial diversity to the global financial system. Islamic financial standard setting organizations play an important role in bridging the gap between Islamic standards and conventional global standards. Such organizations include the IFSB, of which Governor Zeti served as Chairperson last year, and the Accounting and Auditing Organization for Islamic Financial Institutions, which sets accounting standards for Islamic finance. To give a few examples, the IFSB has issued the capital adequacy standard and guidance that complement existing global standards for Islamic banks. Exposure drafts of guiding principles for Islamic collective investment scheme and Islamic insurance, or takaful, will follow. I look forward to the significant role that these Islamic financial standard setting organizations play in the provision of sound and stable Islamic finance services. Epilogue Islamic finance has grown into an industry that is indispensable in understanding the global financial system. The Bank of Japan will closely follow developments in the Islamic finance industry through its IFSB observer membership status. Japanese financial institutions and companies have just stepped into the world of Islamic finance. We hear that some financial institutions are already actively engaged in Islamic finance business by cultivating new markets and setting up local companies. Some companies are already introducing the framework of Islamic finance to finance their projects. I am convinced that we will be seeing more in the near future. I would like to close my remarks by expressing my hopes that the proceedings of this symposium will deepen understanding of Islamic finance among Japanese financial institutions and companies, and that it presents an opportunity for the creation of new financial services. Thank you for your kind attention.
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Summary of a speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, to the Japan National Press Club, Tokyo, 12 May 2008.
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Masaaki Shirakawa: Recent economic and financial developments and the conduct of monetary policy Summary of a speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, to the Japan National Press Club, Tokyo, 12 May 2008. * * * Introduction I am honored to be invited to speak here today to the Japan National Press Club. The club has been called "traditional" in the sense that it is valued for its long history, but it is also known for its tradition of asking speakers tough questions. I once heard from a senior colleague at the Bank of Japan that the governor of a central bank can deliver a speech here only when the economy is performing satisfactorily and he or she is fully confident about the conduct of monetary policy. I am here today to deliver my first speech since being appointed as the Governor of the Bank, not because this is the case, but because I hope your forthright questions will provide me with food for thought and also because this is a good opportunity to explain the Bank's thinking behind the conduct of monetary policy. In the first half of my speech, I will talk about the current situation of and outlook for Japan's economy and the conduct of monetary policy in the near term. In the second half, I would like to explain some basic points that I believe are important for the conduct of monetary policy. I. The outlook for economic activity and prices and the conduct of monetary policy in the near term A. The current situation of and Outlook for Economic Activity and Prices I will first explain the current situation of and outlook for Japan's economy. At the Bank's Monetary Policy Meetings, or MPMs for short, the Policy Board members discuss the outlook for economic activity and prices. At the MPMs held at the end of each April and October, they center their discussion on the outlook for the coming two years. Based on that, the Bank makes public its thinking behind its conduct of monetary policy in the Outlook for Economic Activity and Prices, or the Outlook Report. In the Outlook Report released at the end of April this year, the Bank revised its economic assessment downward from the previous Outlook Report released six months ago, stating that Japan's economic growth was slowing and that deceleration in the economy seemed likely to continue for the time being. The first cause of the slowdown in the economy is the rises in energy and materials prices. The deterioration in the terms of trade that results from such rises leads to a decline in real income, as Japan depends heavily on imported resources. This exerts downward pressure on corporate profits and reduces households' purchasing power, eventually resulting in a decrease in investment and consumption. The second cause is the disruptions in global financial markets and the growing uncertainty regarding overseas economies stemming from the U.S. subprime mortgage problem, which arose last summer. In a situation where concerns exist about the uncertainty of the economic outlook, business sentiment has become cautious – as is evident, for example, in the Tankan (Short-Term Economic Survey of Enterprises in Japan) – and consumer sentiment has also deteriorated. Since the effects of these two causes are likely to persist, deceleration in the economy seems likely to continue for the time being. Thereafter, however, the economy is likely to return to a moderate growth path, as overseas economies are expected to move out of their deceleration phase and the effects of the rises in energy and materials prices are likely to abate. Expressing the outlook numerically, from fiscal 2008 through fiscal 2009, the economy is likely to grow at a pace around the potential growth rate, which is estimated to be 1.5 percent or somewhat higher. This view is supported by the following facts. First, overseas economies, especially emerging economies, are likely to continue to grow at a relatively high rate, although the pace of growth is likely to decelerate slightly. Japan's exports have remained firm as a whole – even though those to the United States have been falling for some time – as they have been increasing at a considerable pace to a broader range of destinations, particularly emerging economies and countries that export natural resources. Japan's exports are expected to continue rising against the background of the rapid growth of these economies. Second, although economic activity might weaken further, it seems that Japan's economy has become more resilient to negative shocks than in the past. In the corporate sector, firms currently face no excess in production capacity, inventory, or employment, and corporate profits have been close to historical highs. As a result of this, Japanese financial institutions are very sound. And third, the accommodative financial conditions are likely to continue to support private demand. Given that currently the uncollateralized overnight call rate is 0.5 percent and the year-on-year rate of change in the CPI is slightly above 1 percent, the shortterm real interest rate is in rough terms 0 percent. The level is very low relative to the potential growth rate, and is also low compared with that in other major economies. Credit spreads, which are added to benchmark interest rates when firms borrow funds, have not been increasing either, unlike in Europe and the United States. Moreover, financial institutions' lending attitudes and firms' liquidity positions have continued to be favorable on the whole, although the situation for small firms has been relatively severe. Turning to prices, the year-on-year rate of increase in the CPI excluding fresh food has been rising since around the end of 2007 due mainly to increased prices of petroleum products and food products, and was 1.2 percent in March 2008. The rate was the highest increase in the 15 years since August 1993, if we disregard fiscal 1997, when retail prices rose due to the rise in the consumption tax. A major factor that affects inflation is the balance between aggregate supply and demand in the economy, or the level of resource utilization in terms of the labor and production capacity. On this point, the level of resource utilization is currently close to its historical average judging from firms' perception of employment conditions and production capacity as seen in the Tankan, as well as from the unemployment rate and the capacity utilization rate. Assuming that the economy grows at around the potential growth rate as I have described, aggregate supply and demand in the economy are likely to remain more or less balanced. Therefore, the supply-demand balance in the domestic economy is unlikely to significantly affect CPI inflation either upward or downward. However, a process is likely to take place in which the rise in energy and materials prices will gradually be passed on to downstream prices, and thus CPI inflation is projected to be around 1 percent for both fiscal 2008 and fiscal 2009. CPI inflation of around 1 percent is consistent with the Bank's "understanding of medium to long-term price stability" and it is where most Policy Board members' median figures of ranges that they understand as being consistent with price stability over the medium to long term are located. Therefore, future developments in the CPI may also be assessed as being within the range of "price stability." In this regard, the price situation in Japan is favorable as compared with major overseas economies, where the inflation rate has been very close to or above the upper limit of the range regarded as consistent with price stability. However, inflation perceived by households in Japan may in fact be higher than the rate of change in the CPI, as suggested by many survey results – for example, the Bank's Opinion Survey on the General Public's Views and Behavior – given that prices of goods that are purchased frequently, such as food products, have been rising noticeably. I think that the Bank should pay close attention to changes in people's perception of inflation, since they may affect the actual rate of change in prices through, for example, consumers' expected inflation rate and firms' price-setting behavior. B. Uncertainty regarding the Outlook for Economic Activity and Prices In the Bank's most likely projection, or the baseline scenario, it is projected that the growth rate of Japan's economy will decelerate for the time being but thereafter the economy is likely to continue its moderate growth with price stability. However, as I will discuss in a moment, an economic outlook is always subject to uncertainties, and currently the situation is one where the degree of uncertainty is especially high. In such a situation, it is necessary to thoroughly and closely assess not only the baseline scenario but also the possibility of the economy deviating either upward or downward from it, that is, the risk scenarios. The first risk to the outlook concerns developments in overseas economies and global financial markets. Disruptions in global financial markets have continued for over six months. In a speech made in early April, Federal Reserve Chairman Ben S. Bernanke said, "I think it is true that the financial distress we are seeing now is among the most severe episodes of the postwar era," and my view is exactly the same. Issuance in markets for securitized products, where the U.S. subprime mortgage problem originated, has been brought to a halt. Looking at corporate finance in the United States and Europe as a whole, credit spreads such as those on corporate bonds have been large. U.S. and European financial institutions have increasingly tightened their lending standards. Amid the tightening of the financial environment, in addition to the drop in housing investment, deceleration in the U.S. economy is becoming more pronounced. It is highly likely that, for the time being, the U.S. economy will experience sluggish growth, or even a moderate recession. The timing and pace of recovery of the U.S. economy will largely depend on when the housing market correction is completed and when the financial environment stops deteriorating. An improvement in the housing and financial markets, in combination with the reductions in the policy interest rate by the Fed and a fiscal stimulus package, will make it more likely that the U.S. economy recovers gradually. However, home prices have yet to stop declining, and there are no signs that the financial market disruptions will abate. In addition, there are risks of a further tightening of financial institutions' lending attitudes. The key is when and how the combined effects of disruptions in financial markets, asset prices, and economic activity will diminish, which is unforeseeable, and this is the biggest source of uncertainty. The second risk concerns developments in energy and materials prices. In the outlook that I described earlier, it is projected that the prices of crude oil and other international commodities will remain elevated, supported by growing demand especially in emerging economies. Considerable uncertainty always surrounds developments in these prices, leaving the potential for movement in either direction. If the rise in international commodity prices is significantly faster than expected, this could further increase inflationary pressures around the world. In that case, there would be a risk of a subsequent economic slowdown through the monetary tightening aimed at preventing inflation. As for the effects on Japan's economy, higher prices of international commodities would not only accelerate inflation but also increase the outflow of income, and this might put downward pressure on the economy. As I have described, there is considerable uncertainty, especially about developments in overseas economies and global financial markets and also high prices of energy and materials, and attention should be paid particularly to the downside risks to Japan's economy. However, it should be borne in mind that everyone, including policymakers, tends to be strongly affected by the current situation when forecasting the future. We should, considering the matter calmly, be aware that the significance of the upside risks will increase if the dense fog surrounding the outlook for the global and Japanese economies gradually clears. It seems that, for the time being, downside risks, rather than upside ones, are likely to be incorporated into the decision-making of households and firms. Nevertheless, it seems that their expectations of future growth in the somewhat longer term are being maintained. In that case, if the downside risks do not materialize and uncertainties become smaller, households and firms may come to expect higher economic growth. If this happens, the current low interest rates will have a stronger impact on Japan's economy. Generally speaking, the prolongation of an accommodative financial environment in a situation where aggregate supply and demand in the economy remain more or less balanced tends to have an unfortunate effect on people's decision-making; they become unconsciously too optimistic in assessing risks, and firms and households as well as financial institutions may overextend themselves, resulting in a long-run misallocation of resources and significant swings in the economy. It seems that the recent economic slowdown as well as increased future uncertainty has reduced the risk that firms and households will overextend themselves. However, if the dense fog surrounding the outlook for the global economy gradually clears and as a result firms and households come to expect higher economic growth than previously, the current degree of monetary policy accommodation is likely to become overly strong relative to the level of economic activity. C. Conduct of monetary policy in the near term Next, I would like to talk about the Bank's conduct of monetary policy in the near term based on the outlook I have just described for economic activity and prices. Six months ago, the Bank indicated in its October 2007 Outlook Report that it would "adjust the level of interest rates gradually in accordance with improvements in the economic and price situation." In the April 2008 Outlook Report, however, the Bank stated, "Given the current situation where the outlook for economic activity and prices is highly uncertain, it is not appropriate to predetermine the direction of future monetary policy." Needless to say, the Bank should, as a central bank, keep in mind that real short-term interest rates are currently at around 0 percent, an extremely low level. Once the Bank thinks that Japan's economy is highly likely to follow a path of sustainable growth with price stability, it will be appropriate to adjust the level of interest rates. At present, however, the situation of Japan's economy demands that most attention be focused on the downside risks. Since the outlook for an economy always entails uncertainty, monetary policy decisions should be made not only based on the most likely projection but also fully taking into account factors that are risks to it. The Bank considers that currently the risks are unbalanced, and in conducting monetary policy more attention needs to be paid to downside risks to the economy stemming from uncertainties regarding future developments in overseas economies and global financial markets as well as the effects of high energy and materials prices. The Bank will pay close attention to future developments in economic activity and prices and, in particular, to whether downside risks will decrease, thereby increasing the likelihood of the economy realizing sustainable growth with price stability, or whether the probability of such risks materializing will rise. So far, I have described the Bank's thinking regarding the conduct of monetary policy in terms of interest rate policy. Now, let me remind you of an important fact: proper functioning of financial markets is a prerequisite for monetary policy to be effective. It is therefore vital to ensure the stability of Japanese financial markets when global financial markets remain volatile. Fortunately, Japanese financial markets have so far been stable unlike their U.S. and European counterparts. Mainly this is because Japanese financial institutions have had only limited exposure to subprime-related products, but I believe that a considerable role was also played by the fact that the Bank, based on its past experience of financial crises, had already established a framework for flexibly providing liquidity. As you know, since last summer central banks in North America and Europe have introduced various tools for liquidity provision to address elevated pressures in short-term funding markets. For example, the Fed has extended the maximum maturity of its funds-supplying operations to one month, from two weeks. The Bank employs funds-supplying tools with a variety of maturities – some of which have a maximum maturity of one year – and this enables the Bank to provide funds with the appropriate maturity. In March this year, the Fed introduced a credit facility that allows securities companies to borrow funds. The Bank has included securities companies as counterparties since 2001, when it introduced a complementary lending facility. As for collateral, central banks in North America and Europe have recently expanded the range of eligible collateral they accept, while the Bank has long accepted a broad range of assets as eligible collateral. Moreover, the Bank has a "pooled collateral" system, which allows counterparties to change their collateral in a flexible manner when necessary. Needless to say, excessive use of such supportive measures may hamper the proper functioning of financial markets, which should operate autonomously, and therefore it is important to maintain a good balance between offering supportive measures and leaving things to the autonomous functioning of the market. What we have learned from Japan's experience in 1997 and subsequent years, however, is that once strains occur in borrowing from the market, smooth borrowing and lending become difficult, and problems cannot be easily resolved. In order to maintain a financial environment in which monetary policy accommodation effects derived from the present low interest rates are fully realized, the Bank will continue to carefully monitor market developments and to ensure the stability of the money market. It will also carefully assess the future outlook for economic activity and prices, closely considering the likelihood of its projections as well as factors posing upside or downside risks, and will implement its policies in a flexible manner. II. Basic thinking concerning the conduct of monetary policy Having dealt with the economic and price situation and the Bank's conduct of monetary policy in the near term, I would now like to spend the rest of the time talking about some fundamental points that I think significant for the conduct of monetary policy. A. The importance of maintaining price stability in the medium to long term First of all, I would like to emphasize the importance of correctly understanding "price stability," one of the objectives of monetary policy. The Bank of Japan Act stipulates that the Bank's currency and monetary control shall be aimed at achieving price stability, thereby contributing to the sound development of the national economy. I strongly support the spirit of this provision, and would like to clarify the important point that "price stability" in the provision means stability that can be sustained in the medium to long term. The public seems to understand, as common sense, that price stability is essential and it is important that it continue in the medium to long term. However, in reality, policy actions aimed at realizing this objective are not necessarily supported by many people all the time. For instance, many of you may remember the situation during the economic bubble in Japan – in fiscal 1987 and fiscal 1988, the year-on-year rate of increase in the CPI stayed in the 0-1 percent range and this, coupled with other factors, caused the public to strongly oppose a possible raising of interest rates, despite the overheating of the economy. I do not think that low interest rates were the only factor behind the economic bubble, nor do I think that it is appropriate to conduct monetary policy with the aim of controlling asset prices. Nevertheless, I consider that, in conducting monetary policy, it is important to monitor various factors influencing the economy, including developments in asset prices, to realize sustainable economic growth with price stability. Assessment of the economic situation with such a wide-ranging perspective may lead to raising of interest rates under certain circumstances, even when price indicators suggest that prices are stable. On the other hand, even when inflation is suggested by data, central banks may need to reduce interest rates in particular situations. A good example would be an increase in consumer prices resulting merely from a temporary rise in crude oil prices due to supply-side factors. Reducing policy interest rates to respond to an economic downturn caused by deterioration in the terms of trade may contribute to ensuring economic growth with continued price stability – although such a policy action should be taken only when energy-related price rises are not leading to broad-based inflation accompanied by higher inflation expectations, in other words, there are no second-round inflation effects. The Bank reviews and releases, annually in principle, the "understanding of medium- to longterm price stability" – that is, the level of inflation that each member of the Policy Board understands as being consistent with price stability over the medium to long term. The latest review conducted at the end of April indicated that there was no major change from the previous review – that is, the "understanding" expressed in terms of the year-on-year rate of change in the CPI currently falls in a range approximately between 0 and 2 percent, with most Policy Board members' median figures at around 1 percent. The Bank conducts monetary policy taking account of the "understanding." B. Forecasts for the economy and prices bearing uncertainty in mind The second point I would like to emphasize is that we should be fully aware of the fact that forecasts of economic activity and prices involve considerable uncertainty. Economic forecasters, including central banks, do their utmost to provide accurate projections of economic activity and prices, but projection errors are often sizable. In the case of projections of the economic growth rate one year ahead presented by central banks as well as private and government organizations, for example, the average historical error ranges exceed 1 percent. This shows the current limit of human ability to predict the future. Considerable uncertainty attends the economic outlook, and it is therefore necessary to keep in mind the possibility that the economy will not evolve as projected, making it a prerequisite in the conduct of monetary policy to perceive factors posing both upside and downside risks. Some experts warned of the risk of a bubble in the U.S. housing market and, furthermore, the possibility of excessive position-taking in credit markets, as these might result in severe economic shocks. It is indeed important to have such a vision regarding the economy. I would, however, hesitate to endorse the opinion that the Fed should have had, a few years ago, a baseline scenario that incorporated a possible bursting of the housing bubble and disruptions in financial markets, and that it should have conducted monetary policy based on the scenario. From the perspective of policymakers, a convincing approach would be one where the possibility of the bursting of a bubble is regarded as a risk factor for the conduct of monetary policy – rather than one where it is incorporated in the baseline scenario. This is the basic concept behind the Bank's approach, where it assesses the baseline scenario, or the most likely outlook – the assessment from the "first perspective" – while assessing various risk factors and the cost that would be incurred should risks materialize – the assessment from the "second perspective." The latest Outlook Report provides, in the form of charts, the aggregated probability distributions compiled from the distributions attributed by individual Policy Board members to the likelihood of divergence upward or downward from their forecast, with the aim of providing more detailed and visual descriptions of the level of risks to the forecast. Each chart shows a bell-shaped distribution with the most likely projection forming the top of the curve. The charts are called Risk Balance Charts, since they indicate how the risks are distributed around the central view and how the distributions are skewed. The Bank released these Risk Balance Charts because it considered that risks that were not deemed most likely by the Bank should also be described in a way that the public could understand easily. C. Complex interdependency between financial and economic developments The third point I would like to mention is that there is a complex interdependency between financial and economic developments, and this should be fully taken into account in assessment of the economic and price situation. This relationship can be seen in Japan's post-bubble experience in the late 1980s, the U.S. IT bubble in the late 1990s, and the recent subprime mortgage problem. It is difficult to explain these cases by using models derived from standard economic theory. What happened in U.S. financial markets recently was a decline in market liquidity. When this occurs, although sellers of financial products in the market offer prices, no one is willing to buy at those prices, resulting in a drastic shrinkage of market transactions. As a result, market participants are unable to take or hedge risks, and this in turn negatively affects economic activity. Unfortunately, there is no perfect explanation of why this complex phenomenon occurs. This makes it all the more important for central banks to continue their efforts to steadily gather and analyze a wide range of data, including information relating to both economic activity and financial conditions as well as information at both the macro- and micro-economic levels, and to update the analysis as new information comes in. I think, while the variety of knowledge and experience accumulated within central banks should be fully mobilized, it is important for them to remain humble, fully recognizing the limits of human knowledge. D. Examining the financial environment The fourth point I would like to make is that assessment of monetary policy effects requires examination of the overall financial environment, including not only the level of nominal shortterm interest rates but also developments in various other interest rates, the state of financial markets' functioning, and the lending stance of financial institutions. Central banks use a short-term interest rate, usually an overnight rate, as their policy interest rate. In Japan, the policy interest rate is the uncollateralized overnight call rate, and the target level is currently set at around 0.5 percent. However, it is not only short-term interest rates that influence the spending behavior of firms and households, but also ones with longer maturities – in other words, all the interest rates that form the yield curve. It is also important to assess the level of interest rates in real terms, taking into account expected inflation rates. Furthermore, it should be borne in mind that firms, when borrowing from banks or from the market by issuing bonds, have to pay higher interest rates than risk-free borrowers such as the government, with spreads added onto the benchmark rates in accordance with their creditworthiness. In some cases, financial institutions may refuse to lend even if a borrower is willing to pay a higher interest rate. Given the facts I have described, when assessing the effects of monetary policy and making policy decisions, it is vital to examine thoroughly not only the appropriate level of the policy interest rate but also the overall financial environment, which is suggested by the shape of the yield curve, the relationship between the level of the policy interest rate and the potential economic growth rate as well as the expected inflation rate, various credit spreads that are added onto benchmark interest rates, and the lending stance of financial institutions. Conclusion I have explained the basic points that are important for the conduct of monetary policy. In closing, I would like to touch upon a few issues related to the organization and behavior of central banks. The first issue relates to the basis for central banks' independence – in other words, why they alone are entitled to conduct monetary policy. I explained earlier that a central bank takes policy action to ensure sustainable price stability in the medium to long term. Such action, however, may not be popular in the short term. What then justifies such action by a central bank? My answer is that accurate research and analysis by a central bank form the basis for the policy decision. The economy is constantly undergoing change, even at this moment, in a situation where economic globalization and development in information and communications technology are in progress. This is why I respect central bank culture, which attaches importance to being humble and always learning. In addition, it is indispensable for a central bank to explain clearly the reasons for its policy decisions – that is to say, it should ensure transparency. After all, a central bank's independence is based on years of experience in making policy decisions based on its accurate analysis, and on transparency with regard to its policy decisions. The second issue relates to the importance of banking operations carried out by central banks. I have spoken today mainly about monetary policy, but a central bank's various banking operations also make an essential contribution to the development of the economy. To cope with the disruptions in global financial markets since last summer, central banks have taken various measures to provide financial markets with ample liquidity, or even acted as an intermediary. Their banking functions have played a crucial role in ensuring that those monetary policy actions take effect smoothly. Despite the unstable functioning of the markets since the summer, payment and settlement systems have not undergone major disruption. When financial markets experience turmoil, foreign exchange transactions are generally prone to settlement risk because of the time difference, and this can jeopardize the markets further. However, such problems have not occurred, and this is partly due to efforts by central banks over many years to enhance the payment and settlement system for foreign exchange transactions. These efforts of major economies' central banks and private banks brought a new system into effect in 2002 that realized settlement on a payment-versuspayment basis of transactions involving a pair of different currencies – for example, the yen and the U.S. dollar or the euro and the dollar. If this system had not been introduced until some years later, turmoil in the markets would have been more extensive. Moreover, preparations for unexpected events are just as important as the banking operations, and central banks have been enhancing business continuity planning for emergencies including earthquakes, terrorist attacks, and system failures. In recent years, monetary policy has been attracting greater attention, and this is indeed welcome. However, it is only one aspect of central banks, and I hope that banking operations performed by central banks as "the bank for banks," their other aspect, will gain more recognition. Through the conduct of the two policies – monetary policy and banking policy – I will dedicate my efforts to ensuring stability in both prices and the financial system.
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Opening speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the 2008 International Conference 'Frontiers in Monetary Theory and Policy', hosted by the Institute for Monetary and Economic Studies, Bank of Japan, Tokyo, 28 May 2008.
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Masaaki Shirakawa: Monetary policy challenges Opening speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the 2008 International Conference "Frontiers in Monetary Theory and Policy", hosted by the Institute for Monetary and Economic Studies, Bank of Japan, Tokyo, 28 May 2008. * * * Good morning. It is my great honor to address the Bank of Japan conference, hosted by the Institute for Monetary and Economic Studies. On behalf of my colleagues at the Bank of Japan, I welcome all the distinguished guests from central banks, international organizations, and academia. The role of monetary policy When I took office as Governor of the Bank of Japan about two months ago, I read again Professor Milton Friedman's well-known presidential address, "The Role of Monetary Policy," given at the American Economic Association Annual Meeting in 1968, recalling my days as a student of Friedman's last class at the University of Chicago. In the address, he put the role of monetary policy this way. The first and most important lesson that history teaches about what monetary policy can do – and it is a lesson of the most profound importance – is that monetary policy can prevent money itself from being a major source of economic disturbance... There is therefore a positive and important task for the monetary authority – to suggest improvements in the [monetary] machine that will reduce the chances that it will get out of order, and to use its own powers so as to keep the machine in good working order... A second thing monetary policy can do is [to] provide a stable background for the economy... Our economic system will work best when producers and consumers, employers and employees, can proceed with full confidence that the average level of prices will behave in a known way in the future – preferably that it will be highly stable. 1 What was intriguing here is that Friedman used the term monetary policy in a much broader context than we define now. Nowadays, the term monetary policy is used almost equivalent to "interest rate policy aiming at price stability." Monetary policy in this sense has been studied intensively and has been refined both in theory and in practice. Yet in his presidential address, Friedman pointed to the maintenance of well-functioning of financial markets and the system as the first role of monetary policy, and price stability as the second role. Of course, not much would be gained here by going deeply into the precision of these definitions, but these words and the terms of Professor Friedman seem to strike a chord with central bankers for two reasons. First, although the monetary policy in a conventional sense and financial system policy are usually considered as different policy prescriptions, they become related in a complicated and delicate manner in critical phases. Second, while policy instruments employed by a central bank essentially aim at providing or allocating liquidity, such instruments are not earmarked for each policy and its objective, namely, price stability or financial system stability. The distinction between these two policies is often not that clear. See Friedman (1968). Experience of the bubble and its bursting Such interrelation came to the fore during the bubble period Japan experienced since the latter half of the 1980s. As you are all aware, Japan's bubble was unprecedented in modern economic history: leverage expanded and asset prices rose sharply and vastly. In those circumstances, tangible investments took place that could only be justified as long as increases in asset prices would continue forever. Once the bubble burst, a massive amount of economically unworthy assets were left behind. In other words, asset markets failed in making efficient intertemporal allocation of resources, which per se became the source of economic turmoil. The question of the relationship between monetary policy and the bubble is quite complex and the clear answer is yet to be provided. In that regard, many economic agents at that time had expectations that low interest rates would continue for a long time. I cannot convincingly say that had nothing to do with the bubble formation. Around 1988, those who argued for raising interest rates were a minority including academia or international organizations, given the extremely subdued inflation rate under the overheating economy. The annual growth rate of the consumer price index had been negative until March 1987 and the annual increase was only 0.7 percent in fiscal 1988 as a whole. Once the bubble burst, asset prices plunged and the capital of firms and financial institutions rapidly eroded, thereby inflicting severe damage on the entire economy. In particular, in Japan's financial system where banks played a predominant role in financial intermediations, the effects stemming from undercapitalization of the banking sector were extremely severe. During the initial periods after the burst of the bubble, adverse effects on the economy were brought about by a decline in demand from a high level and the negative wealth effect stemming from the plunge in asset prices. Subsequently, it became evident that the dominant channel was lower productivity stemming from the misallocation of resources, as a result of the malfunctioning of financial intermediation. Currently, the United States and major European countries are experiencing financial turmoil in credit and funding markets. While there are some similarities between the current turmoil in the U.S. and Japan's experience during and after the bubble period, there are also various differences. Let me first point out the differences. First, the amount of losses seems to be quite different. The losses of Japanese deposit-taking institutions during the bubble period totaled some US$1 trillion. On the other hand, in the current financial turmoil, the IMF estimated the worldwide loss to be approximately US$945 billion, of which about half was incurred by banking sector, although these IMF estimates were based on various assumptions and thus warrant care in interpreting. Second, in the United States, the losses of securitized products, which triggered the recent turmoil, could be recognized through prices traded in the markets. In the case of Japan, however, the losses were concentrated on non-tradable loan assets that lacked marketability, and thus, together with drawbacks in accounting systems, led to a delay in recognizing the losses. Third, in the U.S., financial institutions that had suffered massive losses promptly raised capitals. There are also similarities. Arguably, the bubble was formed, expanded, and burst. It is also common in both cases that a plunge in asset prices exerted adverse effects on the real economy through the deterioration of the financial side. Based on Japan's experience, how the negative feedback loop of tighter financial conditions, a decline in asset prices, and the deteriorating real economy will evolve could be key to the future course of the economy. Challenges for monetary policy The recent and current episodes of financial turmoil in the past twenty years show that central banks face various challenges in the context of monetary policy as broadly defined by Friedman. The first challenge is how we should define and understand price stability which is an objective of monetary policy. Be it in Japan or in the U.S., many of recent bubbles occurred, quite paradoxically, following continued low interest rate period after price stability was achieved or deflation scare heightened. While how a decline in inflation or low interest rates relates to aggressive risk-taking by economic agents is yet to be clarified, the experience of the bubble and its burst tells us that the economy sometimes responds in a nonlinear manner. During such a nonlinear process, complicated dynamics such as the feedback loop between the real and financial side of the economy play a decisive role. In other words, the first and the second role of monetary policy as identified by Friedman are closely related to each other. While policymakers and economists understand that price stability represents a situation in which prices could remain stable in a medium to long term, inflation dynamics could evolve with a long lag and accompany nonlinear effects. Against such a backdrop, if we focus narrowly on the current observed inflation rate, there is a risk that necessary monetary policy adjustments might be delayed, inducing large fluctuations in economic activities. In that regard, central banks around the globe seem to strive for exploring optimal ways to communicate a quantitative expression of price stability with different consequences. Central banks under an inflation targeting regime announce the target level of inflation rate. The Bank of Japan and the European Central Bank (ECB) announce some kind of numerical definition of price stability, while the Federal Reserve provides a medium-term forecasted value of inflation given the current economic conditions and appropriate policy. The second challenge is how to design financial system policy. Although we can recognize a risk of a nonlinear change of the economy such as the burst of the bubble, we cannot take preemptive monetary easing before a bubble burst. It is impossible to forecast precisely when the burst will take place. Once we recognize such a change, it is appropriate to cut the policy interest rate more than the standard Taylor rule suggests, as with the current policy by the Fed. At the same time, the Japanese experience shows that it is quite difficult to create sufficiently benign financial conditions only with a reduction in the policy interest rate when the balance sheets of firms and financial institutions are severely devastated. When looking at the current U.S. financial situation, the yields of corporate bonds with low credit standings have not been reduced yet compared with the level in summer 2007, despite the massive decrease in the policy rate. The fact suggests that in addition to the policy interest rate changes ex post, it is important to design a policy and institutional framework less prone to the formation of a bubble ex ante. While I have already mentioned possible measures in terms of monetary policy, how to align supervision and regulations remains an important challenge that needs to be addressed, so as not to let financial institutions' behaviors amplify economic fluctuations. The third challenge is the so-called banking policy of central banks. For effective monetary policy, stable financial system and well-functioning financial markets are indispensable. The events since summer 2007 have highlighted that the loss of market liquidity has played a crucial role. Although the mechanism of drying up market liquidity has not yet been fully investigated, central banks have been making efforts to restore market liquidity by means of their own banking functions. In that regard, the Bank of Japan has shown itself to be at the frontiers. For example, in 2001 it introduced a new method of liquidity provision with relatively longer maturities to a wider range of financial institutions. This is equivalent to the Term Auction Facility (TAF) introduced by the Fed in December 2007. In 2001, the Bank of Japan introduced a standing facility to financial institutions including securities companies. 2 It corresponds to the Primary Dealer Credit Facility (PDCF) introduced by the Fed in March 2008. In addition, the Bank of Japan carried out a twist operation – a mixture of liquidity provision and issuance of bills sold, where a central bank acts as a kind of broker in the money market. Furthermore, it purchased asset-backed securities, and purchased stocks As for the actions taken in 2001, see Bank of Japan, Open Market Operations Division (2001, 2002). held by banks. All those measures were policy prescriptions aimed at revitalizing the functioning of financial markets and financial system. Although they would not usually be classified as monetary policy measures, the effects of monetary policy cannot be evaluated without considering the banking policy conducted by a central bank. In the changing financial environment, central banks are bound to continuously review their operations. Concluding remarks The challenges I have described are very practical for central banks. While they are all quite difficult ones for central banks to tackle, central banks should conduct their policy by finding the answers to them one by one. In such a process, central banks make the most of available academic wisdom. Central banks often face situations unexplained by existing theories. For that very reason, I believe that central banks must be ever learning institutions. At the same time, we should make efforts to convey to academia whatever puzzles we have found in practice. In turn, the theories developed in academic circles would find their way to be fed back to central bank circles as valuable input for the proper conduct of monetary policy. I am convinced that candid and inspiring discussions in various aspects of monetary policy will take place at this conference, that the discussions will be applied to the future policy implementation among central banks, and that the nexus between practice and theory will push back the academic frontiers furthermore. Thank you for your attention, and I wish you a big success of the conference. References Bank of Japan, Open Market Operations Division, "Money Market Operations in FY2000," Market Review, 01-E-4, 2001. ---, ---, "Money Market Operations in FY2001", Market Review, 02-E-3, 2002. Friedman, Milton, "The Role of Monetary Policy", American Economic Review, 58 (1), 1968, pp. 1-17.
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Keynote speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the 2008 International Monetary Conference, Barcelona, (via satellite), 3 June 2008.
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Masaaki Shirakawa: Japan’s economy and monetary policy Keynote speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the 2008 International Monetary Conference, Barcelona, (via satellite), 3 June 2008. * * * Thank you, Mr. Chairman. I will give you my thought on Japan’s economy and monetary policy in the present context. With regard to the global economic conjuncture, I don’t have much to add to the views expressed by my colleagues. In light of the persistent tensions in financial markets and slowing growth in the advanced economies, we need to keep a close watch on how the negative feedback loop between financial markets, asset prices and the real economy will play out going forward. Uncertainties surrounding this adverse dynamics are still substantial. Meanwhile, the global economy is facing greater inflationary pressures with commodity prices hitting all-time highs. Since the surge in commodity prices has continued for the past several years, strong demand from emerging market economies probably plays a substantial role in this phenomenon. In these circumstances, both developed and emerging market economies are facing the difficult balancing act between maintaining sustainable economic growth on the one hand and anchoring longer-term inflationary expectations on the other. These global economic forces, both downside and upside, affect Japan’s economy through a variety of channels, adding to uncertainty for policy-makers. In this situation, Japan’s economy is slowing because of the deterioration of the terms-of-trade associated with higher import prices. Corporate earnings are squeezed by soaring energy and raw material prices, and industrial production and capital investment are losing traction somewhat. Business sentiment is increasingly on the cautious side with greater downside risks to the global economic outlook. As these headwinds are likely to stay for some while, Japan’s economy seems to slow for the time being. With regard to the baseline scenario for the next one to two years, however, I am of the view that Japan’s economy will grow near potential. To be more specific, Japan’s growth rate will pick up again after some hiatus to reach one-and-half percent in 2008 and somewhat higher in 2009, both of which are close to Japan’s potential growth rate. Let me elaborate on this from three perspectives. First, Japan’s exports have been and will continue to be robust. Exports to the United States have weakened in tandem with the U.S. economic slowdown, but this is more than offset by strong growth in other regions – major emerging market economies and resource-rich countries in particular. Thus, Japan’s whole exports are growing briskly toward a wider range of areas and/or countries. In a nutshell, strong external demand is counter-balancing the negative terms-of-trade effects which I mentioned earlier. Second, Japan’s economy has improved resilience in recent years. In the late 1990s, for example, Japan’s economy accumulated excesses in a variety of forms which made it doubly vulnerable to various shocks. But now, the corporate sector is not under the burden of those excesses, and the aggregate business profits are close to record levels. Owing to improved resiliency of corporate borrowers, Japan’s financial sector is on a sounder footing as well. Third, Japan’s easy monetary conditions will continue to support demand. The real shortterm interest rate is in the neighborhood of zero. In addition, unlike in the United States and Europe, credit spreads are relatively compressed. On the inflation side, Japan’s core CPI inflation, which excludes fresh food, has edged up in recent months to hover around 1 percent, and the 1.2 percent increase for this March was the highest in almost 15 years except in 1998, when Japan’s consumption tax rate was raised. According to our April projections, our CPI inflation rate is expected to be around 1 percent in both 2008 and 2009. But more recently, signs are emerging that upside risks on the inflation front increase gradually amid rising energy and food prices. Therefore, we are closely watching whether corporate pricing behavior will change and how general inflationary expectations will evolve going forward. This vigilance is important because higher input costs are gradually feeding through into the down-stream, and there are some indications that inflation sentiment among consumers might be slowly growing. Having said all this, I think the risk balance for growth is still slanted to the downside, while pressures on prices are on the upside. At the same time, though, it is true that Japan’s monetary conditions have been extremely accommodative for quite some time. In this light, we bear it in mind that if this monetary accommodation is maintained for long while downside risks subside, it might accentuate future cyclical swings in the economy by, for instance, encouraging excessive risk-taking. With respect to monetary policy stance in this fairly uncertain environment, the Bank of Japan has no prejudgment about the future direction of policy rates. Examining the likely path of growth and inflation for the next one to two years while assessing the changing risk balance from a longer perspective, the Bank of Japan will make an appropriate judgment in a flexible manner in order to ensure sustainable economic growth with price stability. Lastly, let me finish up with a few remarks about Japan’s financial markets. On the whole, Japan’s financial markets function well. For example, because of the market turmoil over the past ten months, Japan’s TED spread, defined as the inter-bank offered rate minus the T-bill rate, has widened by 25 bps, while those spreads in the U.S. and European markets expanded by 100 bps and 70 bps respectively. The prime reason for this relative stability of Japan’s markets is that Japan’s financial firms have smaller exposures to structured credit markets than their foreign competitors. In addition, I believe the flexible framework of our money market operations has contributed to preserving the stability of short-term funding market. The Bank of Japan has acquired this operational flexibility over time, including through its experience of the financial crisis in the last decade. Let me discuss this from three angles. First, the Bank of Japan sets the maturity of market operations quite flexibly, from O/N to one year, depending upon prevailing market conditions. Flexibility in liquidity-draining operations such as bill-selling operations also makes it possible to provide large quantities of funds without worrying too much about excess reserves being left in the system. Second, the Bank of Japan executes market operations with a broad range of counterparties, banks, securities houses, and money market broker-dealers. Third, our collateral regime is efficient and user-friendly. Under the so-called pooled collateral scheme which covers not only regular market operations but also the standing lending facility and day-light overdraft, counterparties are able to pledge a variety of collateral in advance, ranging from government securities to private-label debts including asset-backed securities. When faced with increased stress in the money market over the past ten months, the Bank of Japan responded by providing ample liquidity or supplying longer-term funds earlier than usual. These operations, conducted within the normal operational modalities, enabled us to control short-term interest rates without serious difficulties. In short, I am reminded that financial market stability is essential for effective monetary policy.
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Statement by Mr Masaaki Shirakawa, Governor of the Bank of Japan, concerning the Banks Semiannual Report on Currency and Monetary Control before the Committee on Financial Affairs, House of Councillors, Tokyo, 22 May 2008.
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Masaaki Shirakawa: Overall review of the Bank of Japan’s conduct of monetary policy Statement by Mr Masaaki Shirakawa, Governor of the Bank of Japan, concerning the Bank’s Semiannual Report on Currency and Monetary Control before the Committee on Financial Affairs, House of Councillors, Tokyo, 22 May 2008. * * * Introduction The Bank of Japan submitted its Semiannual Report on Currency and Monetary Control for the first half of fiscal 2007 to the Diet on December 11, 2007. I am pleased to have this opportunity to present an overall review of the Bank's conduct of monetary policy. I. Developments in Japan's economy Japan's economic growth is slowing, mainly due to the effects of high energy and materials prices. The deterioration in the terms of trade that results from rises in energy and materials prices leads to an outflow of real income, as Japan depends heavily on imported resources. This exerts downward pressure on corporate profits and reduces households' purchasing power. Although business fixed investment and private consumption remain firm, due attention should be paid to the possibility that the weakening of the economy's capacity to generate income will result in weaker domestic private demand. As for the outlook, Japan's economy is likely to grow at a slower pace for the time being and follow a moderate growth path thereafter. Exports are expected to continue rising – even though those to the United States have been falling for some time – as they have been increasing to a broader range of destinations, particularly emerging economies and countries that export natural resources. In the corporate sector, firms currently face no excess in production capacity, inventory, or employment, and corporate profits have been at historically high levels. As a result, it seems that Japan's economy has become more resilient against negative shocks than in the past. The accommodative financial conditions are likely to continue to support private demand. The level of short-term interest rates has been very low relative to the potential growth rate and inflation. In addition, firms' liquidity positions and funding conditions have continued to be favorable on the whole. However, the liquidity positions of small firms and some nonmanufacturing firms are increasingly unfavorable, and therefore developments need to be closely monitored. Global financial markets have been unstable due to continued disruptions stemming from the U.S. subprime mortgage problem. Although overly pessimistic views about global financial markets have subsided compared with some time ago, the deterioration in the functioning of the U.S. and European markets for securitized products has remained significant and strains in money markets have persisted. Moreover, financial institutions have increasingly been tightening their lending standards. Against this background, the global economy – including the U.S. economy, which has been decelerating even more clearly – has continued to be exposed to downside risk. At the same time, the risk of inflation has been increasing globally, as prices of crude oil and other international commodities have been rising substantially. The Bank considers it necessary to continue to carefully monitor developments in overseas economies and global financial markets as well as the effects of the rise in materials prices. Regarding prices, the three-month rate of change in the domestic corporate goods price index has been positive, mainly due to the rise in international commodity prices. The yearon-year rate of increase in the CPI (excluding fresh food) has been rising since around the end of last year, and it has been around 1 percent lately. As for the outlook, it is projected to continue to be positive due to the rise in prices of petroleum products and food products in a situation where overall supply and demand in the economy are more or less balanced. Given that the current increase in the CPI is the highest in 15 years – if we disregard fiscal 1997, when retail prices rose due to the rise in the consumption tax – and that the prices of daily necessities are rising markedly, close attention should be paid to the effects of price developments on consumers' inflation expectations and the price-setting behavior of firms. II. Conduct of monetary policy and disposal of stocks purchased from financial institutions As I have explained, the outlook for economic activity and prices is highly uncertain at present. In this situation, the Bank considers that it is not appropriate to predetermine the direction of future monetary policy. Based on a thorough examination of the economic and price situation as well as the market situation both at home and abroad, the Bank will carefully assess the future outlook for economic activity and prices, closely considering the likelihood of its projections as well as relevant risk factors, and will implement its policies in a flexible manner. The Bank has been appropriately providing liquidity through money market operations. As a result, despite the continued disruptions in global financial markets, Japan's money market has been stable, unlike its U.S. and European counterparts. The Bank will continue to carefully monitor market developments and to ensure, via appropriate money market operations, the proper functioning of the money market. With regard to stocks purchased from financial institutions through the stock purchasing program implemented between November 2002 and September 2004, the Bank has been disposing of them in the market since October 2007. The book value of the remaining stocks held by the Bank was approximately 1.4 trillion yen as of the end of April 2008.
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Summary of a speech given by Mr Masaaki Shirakawa, Governor of the Bank of Japan, to the Naigai Josei Chousa Kai (Research Institute of Japan), Tokyo, 18 July 2008.
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Masaaki Shirakawa: The recent economic and financial developments and their outlook, and the conduct of monetary policy in Japan Summary of a speech given by Mr Masaaki Shirakawa, Governor of the Bank of Japan, to the Naigai Josei Chousa Kai (Research Institute of Japan), Tokyo, 18 July 2008. * * * Introduction I am honored to be invited to speak here today to the Naigai Josei Chousa Kai. As you are all aware, the outlook for the world economy is currently extremely uncertain and policy making has become increasingly difficult. The recent upsurge in energy and materials prices is increasing inflationary pressures globally and, at the same time, putting downside pressures on the economy in many countries consuming these resources. In addition, turmoil in global financial markets stemming from the subprime loan problem in the United States has in no way subsided. Central banks are facing the difficult challenges of maintaining stability in economic activity and prices and also in financial markets. The Bank of Japan is also facing these challenges. Confronted with downside risks to the economy and upside risks to prices at the same time, which is unusual, the Bank must appropriately steer monetary policy. In addition, given the difficult situation, it is becoming increasingly important for us as policy makers to accurately communicate to market participants and to the general public our assessment of the situation and issues facing Japan's economy. In the first half of my talk today, I would like to discuss the Bank's view on the current situation and the outlook for Japan's economy and then to elaborate on the thinking behind our monetary policy under such circumstances. In the latter half of my talk, I would like to discuss how we are trying to convey our assessment of the economic situation and the thinking behind our conduct of monetary policy, in other words, the role and the framework of communication regarding the conduct of monetary policy. 1. Outlook for economic activity and prices and the conduct of monetary policy Current economic situation and the outlook I would first like to discuss the current situation of Japan's economy. Since 2002, Japan's economy has enjoyed a moderate but prolonged period of economic expansion. The basic background for the expansion has been the high growth of the world economy, mainly of emerging economies, and the efforts of Japanese firms to restructure their businesses. Although an average of around 2 percent GDP growth between 2002 and 2007 does not seem remarkable, it was somewhat above the potential growth rate and has closed the output gap. Since the end of last year, however, the pace of economic growth has gradually slowed. Initially, this was mainly due to the sudden fall in housing investment reflecting the revision of the Building Standard Law. Subsequently, however, the growth in domestic private demand moderated due to weaker corporate profits and a decline in the real purchasing power of households against the background of the upsurge in energy and materials prices. Given that the sharp rises in energy and materials prices continue to date, it is judged that economic growth is slowing further. Since Japan relies for various resources heavily on imports, increases in energy and materials prices imply an outflow of income to overseas. For example, relative to early 2002, Japan's export prices have decreased by around 5 percent whereas import prices have risen by around 60 percent, causing a deterioration in Japan's terms of trade. The deterioration in the terms of trade has been especially acute recently. Corporate profits have started to decrease and the growth in corporate fixed investment is slowing. In the household sector, real purchasing power has decreased since prices are rising while growth in wages remains moderate, and private consumption is becoming somewhat sluggish. What is the outlook for the future then? As I said at the outset, the environment surrounding domestic and overseas economies is quite uncertain and to make economic forecasts, it has become necessary, more than usual, to carefully consider the most likely outlook, the main scenario, as well as various factors causing uncertainty. The outlook that we have as the main scenario is that, while Japan's economic growth will likely remain slow for the time being, it is expected to gradually return onto a moderate growth path thereafter without experiencing a deep adjustment phase. There are three reasons for this outlook. First, the robustness of Japan's economy against external shocks has been remarkably strengthened compared with the past. As a result of restructuring efforts during the prolonged adjustment phase after the burst of the bubble, Japanese firms currently face no pressure to adjust production capacity, inventory, or employment. For this reason, the likelihood of any shock triggering a large-scale adjustment seems small. Second, with respect to the financial system, losses incurred by Japanese financial institutions due to the subprime loan problem are limited compared to those of U.S. and European financial institutions and financial markets remain stable. Third, the growth in the world economy, which is providing a favorable environment for Japanese exports, is likely to be maintained. The economic growth rate in emerging economies and countries that export natural resources will likely remain high and it is also relatively likely that the current phase of slow growth in advanced economies will come to an end and the growth rate will gradually recover. What are the risk factors that may hamper the realization of this main scenario? Two major risk factors could be pointed out. The first is the upsurge in commodity prices and the global increase in inflationary pressures. The second is the developments in global financial markets and in the U.S. and European economies under the influence of the subprime loan problem. I will first discuss the upsurge in commodity prices, such as prices of energy, materials, and food, and the global increase in inflationary pressures. The upsurge in commodity prices seems attributable mainly to the sharp increase in demand reflecting high growth in emerging economies and countries that export natural resources, and to the slower growth in production capacity relative to the increase in demand. In addition, speculative or financial factors have been pointed out. Although various factors could be thought to have contributed to the actual rise in commodity prices, it seems possible to attribute the trend increase since 2002 basically to the fundamental factor, which is the condition of supply and demand. In the 1990s and in the early 2000s, the inflation rates in advanced economies gradually declined with the formerly planned and emerging economies joining the world of the market economies. During this period, the world economy enjoyed favorable economic conditions of high growth, low inflation, and low interest rates with some differences between countries and times. As the process advanced, however, formerly planned economies and emerging economies increased their presence not only as production bases of labor intensive goods but as huge consumers of materials and consumer products. In fact, in 2007 the demand for crude oil declined 0.8 percent for OECD countries, which are advanced economies, whereas it increased 3.9 percent for non-OECD countries. What began as an upsurge in commodity prices including energy and materials is now leading to an increase in overall inflationary pressures. The headline consumer price inflation rates, which include energy and food, are currently around 4 percent in the United States and the euro area, and have increased around 2 percent relative to a year earlier. The U.S.-type core inflation rate, which excludes energy and food, is over 2 percent. In emerging countries, the inflation rates are much higher: in China, it is around 7 to 8 percent and there are a number of countries with double-digit inflation rates, such as Russia, Indonesia, and Saudi Arabia. The fact that inflation rates are increasing worldwide gives rise to the following questions. Was the high world growth during the past several years sustainable? Were sufficient macroeconomic policy measures taken? In fact, the continuance of an extremely accommodative financial environment worldwide has often been referred to as global excess liquidity or a savings glut. However, since the turn of the year, especially during the past several months, an increasing number of countries are shifting their monetary policy in a more restrictive direction. Whether sustainable world growth with price stability is attainable through appropriate macro-economic policy measures applied in various parts of the world has much bearing on the ability of Japan's economy to realize the outlook which I have referred to earlier. But, I must say, every country is confronted with difficult tasks. In the United States, the economy faces with the difficult issues of stagnation, inflationary risks, and the problem in the financial system. In the case of emerging countries, an increasing number of countries are facing the issue of balancing their policy objectives such as sustained high growth and price stability with the management of a de facto fixed foreign exchange system. In any event, the key issue is whether a sustainable pace of world growth can be achieved though with some moderation in the rate of growth. I will now turn to discuss developments in global financial markets and in the U.S. and European economies, which are the second factor casting uncertainty over Japan's economy. Global financial markets have been unstable as a result of the subprime loan problem. The nature of this problem, however, seems to have evolved over time. In the beginning, the values of various securitized products, including those packaged with subprime mortgage loans, declined. As a result of this, financial institutions incurred large losses and their capital decreased. Confronted with this situation, financial institutions have tightened their credit standards and this has exerted downward pressure on economic activities. Currently, the stage of realizing losses on securitized products has almost been completed. However, reflecting sluggishness in the economy, rates of delinquency on housing loans as well as commercial property loans and consumer loans have been increasing, and the effects of the decline in financial institutions' asset quality on the economy are becoming a concern. It is still not clear when and how the negative feedback loop between capital markets, asset prices, and the real economy will start to move toward resolution in the United States. Apart from the subprime loan problem in the United States, there are cases in other advanced economies where fluctuations in asset prices are exerting adverse effects on the financial systems. With turmoil in global financial markets continuing, downside risks to the U.S. and the world economy continue to be high. The current state of inflation and its outlook I will now turn to the topic of developments in prices in Japan. The twelve-month increase in the CGPI recorded 5.6 percent in June due mainly to the rises in prices of steel and petroleum products. This was the highest rate of increase since February 1981. CPI inflation excluding fresh food had remained around zero until around the fall of last year but started to increase thereafter, mainly due to the rises in petroleum products and food, reaching 1.5 percent in May. Excluding fiscal 1997, when CPI inflation increased reflecting the increase in the rate of consumption tax, this was the largest increase since March 1993. Although it is still low relative to other countries I have mentioned, this is a big change considering the long trend of price stability experienced in Japan. To examine the outlook for inflation, I would now like to analyze the situation in terms of the three most important factors affecting prices, which are domestic supply and demand conditions, import prices, and inflation expectations of firms and households. The first factor, domestic supply and demand conditions, is currently more or less balanced. Assuming that the economic outlook to which I just referred is realized, the situation will remain roughly the same going forward. This indicates that domestic supply and demand conditions are unlikely to be a factor causing a large fluctuation in prices. The second factor, import prices, has already affected the CGPI and the CPI to a considerable degree through increases in energy and material prices and passing on of such cost increases to sales prices, and it will likely continue to be an important influence. The third factor, inflation expectations, is theoretically an important factor affecting the inflation rate. The key is whether the increases in energy and materials prices will bring about a "second-round effect" of further increases in wages and prices through heightening of the inflation expectations of firms and households. In fact, after the first oil shock in the 1970s, this "second-round effect" significantly increased prices and led to the situation often called "runaway inflation." So far, the annual increase in wages has remained at around 1 percent and, even considering other data, there seems to be no sign that the "second-round effect" is taking hold in Japan. Therefore, it is likely that future inflation will depend mainly on developments in energy and materials prices and the degree of pass-on of these cost increases to sales prices. As the main scenario, we assume that CPI inflation is likely to become somewhat elevated in the coming months but gradually moderate thereafter. However, for the time being, this scenario is not without upside risks that we must be aware of. The major risk is developments in energy and materials prices. We also cannot rule out the possibility of changes in economic agents’ inflation expectations, which so far have remained stable. With recent increases in prices of daily necessities such as food, the rate of inflation actually felt by households seems to have shifted upward. According to the Bank’s quarterly Opinion Survey on the General Public's Views and Behavior conducted in June, more than 90 percent felt that prices have gone up. Since the public's perception of inflation affects the actual inflation rate through inflation expectations and changes in the price-setting behavior of firms, it needs to be monitored carefully along with developments in energy and materials prices. The conduct of monetary policy With this outlook for economic activity and prices as well as the risk factors in mind, I would now like to turn to the subject of the conduct of monetary policy. Since the termination of the so-called quantitative easing monetary policy in March 2006, the Bank had been conducting monetary policy based on the idea that the level of the policy rate, the uncollateralized overnight call rate, should be raised gradually in accordance with improvements in the economic and price situation. Since the end of last year, however, economic growth has entered a phase of deceleration while the rate of inflation has increased. In addition, uncertainties in global financial markets and overseas economies have heightened. In view of these developments, the Bank is currently taking the stance that future monetary policy should not be predetermined and should be implemented in a flexible manner through careful assessment of the outlook for economic activity and prices, closely considering the likelihood of the Bank’s projections as well as factors posing upside or downside risks. In the current circumstances, what is important is how monetary policy should deal with the so-called "supply shocks," or increases in energy and materials prices. There are two orthodox principles shared by central banks in advanced economies based on their experience of such problems, particularly oil shocks. First, a temporary increase in import costs due to a supply shock should not be dealt with by increases in interest rates. Second, if there is a risk of a "second-round effect" being induced by increases in inflation expectations, it should be dealt with by increases in interest rates. With respect to the ongoing rise in commodity prices, it cannot be taken as "temporary" since it has been continuing for some time. In addition, the ongoing rise in commodity prices is not only caused by supply-side factors but also influenced strongly by the increases in global demand I referred to earlier. Therefore, what needs to be assessed in the conduct of monetary policy under the situation of rising import costs could be summarized in the following three points. First is how the influence of two forces working in different directions -- the decrease in domestic demand caused by the outflow of income due to the upsurge in materials prices, and the increase in exports against the background of stronger global demand mainly in emerging economies and countries that export natural resources -- is affecting Japan's economy. Second is how such developments in economic activities will affect price situations. And third is how the increase in commodity prices and the resulting increase in actual inflation is affecting the inflation expectations of households and the price-setting behavior of firms. The conduct of monetary policy in an economic situation like today’s is often referred to as "keeping an eye on both the economy and prices." However, this is not a compromise approach of simply balancing both sides. There needs to be a basis of judgment on the conduct of monetary policy when economic activity and prices are displaying irregular developments, and many central banks including the Bank of Japan attach great importance to the third point above, which is whether the stability in the expected rate of inflation is maintained. The Bank, in light of the monetary policy objective of attaining sustainable growth with price stability, will assess not only the main scenario referred earlier but also the risks of it deviating either to the upside or the downside and conduct monetary policy in an appropriate manner. 2. Central bank communication on monetary policy So far, I have discussed the outlook for economic activity and prices and the conduct of monetary policy. What is important in conducting monetary policy is the appropriate assessment of economic conditions. If, however, the content of policy decisions and their background are not accurately communicated, there is a risk of monetary policy not fully achieving its intended aims. In addition, independent central banks should be accountable for the basis of their policy decisions as well as actual decisions. Central banks worldwide have been making efforts to improve communication on monetary policy, giving due consideration to the situation in each country, to improve the effectiveness of monetary policy and to be accountable. At the most recent Monetary Policy Meeting, the Bank decided to adopt several enhancements to its communication strategy on monetary policy. In the latter part of my talk today, I would like to expand a little on the topic of central bank communication. The contents of communication on monetary policy I would first like to discuss three important elements on which the communication on monetary policy is based. The first of these is the objective or the aim of monetary policy. The second is the assessment of the current situation of the economy and prices and the outlook for both. And third is the thinking behind the future conduct of monetary policy. The first element, the objective of monetary policy, is, in many countries, stipulated in the law governing the central bank as contributing to sustainable economic growth through stability in prices. In Japan, Article 2 of the Bank of Japan Act clearly states that it is "achieving price stability, thereby contributing to the sound development of the national economy." On the other hand, the ways price stability is numerically expressed differ notably from country to country. In the case of the Bank, the level of inflation rate that each Policy Board member understands as being consistent with price stability over the medium to long term is compiled and published as the "understanding of medium- to long-term price stability." The current understanding falls in the range approximately between 0 and 2 percent, with most Policy Board members' median figures at around 1 percent. The second important element is to communicate the assessment of not only the current situation of the economy and prices but also their outlook. This is because it takes some time for monetary policy to actually affect economic activity and prices. In addition, since the outlook for economic activity and prices always entails uncertainties, it is necessary, when communicating it, to not only present a single scenario, but also to clarify the risks that might result in an upside or downside deviation. In the case of the Bank, economic and price situations are communicated through means such as the Monthly Report of Recent Economic and Financial Developments and the press conference held after each Monetary Policy Meeting. Also in the semiannual Outlook for Economic Activity and Prices (Outlook Report), which is published in April and October, projections for the current and the next fiscal year as well as risk factors are published. Starting this April, Risk Balance Charts were introduced to visually express future uncertainties by means of aggregated probability distributions of forecasts of economic growth and inflation by individual Policy Board members. The third important element is explaining the thinking behind the future conduct of monetary policy. How much this should be explained depends on the economic situation. What is important is that the thinking behind the future conduct of monetary policy depends on the economic and price situation of the time and this should be communicated along with the outlook for economic activity and prices and its risk factors. In March 2006, the Bank adopted the idea of outlining its assessment of economic activity and prices, which forms the basis of monetary policy conduct, from "two perspectives." In the first perspective, the Policy Board members examine whether the outlook deemed most likely is consistent with the objective of monetary policy, which is the attainment of sustainable growth with price stability, whereas in the second, risk factors that are not captured in the outlook deemed most likely are examined. The Bank, in the light of deliberations from the "two perspectives" described above, outlines its view on future monetary policy, and discloses it in the Outlook Report. Issues for central bank communication In recent years, ways of communicating monetary policy have been actively discussed from the viewpoint of improving the transparency of monetary policy. I would like to discuss a few of these issues facing central banks in the context of the current economic situation. First is the issue of harmonizing the diversity and transparency of the monetary policy committee. Many central banks, including the Bank of Japan, have the system of decision making by a committee. The final decision on the level of the policy interest rate is made by a majority vote but, in the process, diverse views are expressed on the situation of the economy and prices and the basic thinking behind the conduct of monetary policy. Although this diversity of views is one of the advantages of a committee system, how the central bank's view should be drawn together and released is an important issue. Second is the issue of how risks and uncertainties should be communicated. Since the transmission lag of monetary policy is long and variable, it is necessary to reveal the outlook for a certain time horizon. Needless to say, uncertainty increases as the time horizon lengthens. In addition, with complex interactions between the monetary and the real sides of the economy, it is usually difficult to anticipate when risks will actually materialize even if they are qualitatively recognized. In the case of the current subprime loan problem, for example, excesses in financial activities and the risk of their reversals had been pointed out quite early by many central banks in their publications such as financial system reports. However, it was impossible to anticipate when it would actually happen. How qualitative and quantitative assessments of the outlook and risk factors should be communicated is an important issue facing central banks. Third is the issue of how central banks' rationale behind the conduct of monetary policy should be communicated. Some argue that a transparent monetary policy should signal an impending decision to market participants before the next Monetary Policy Meeting. I do not think so. De facto announcement of the future level of the policy interest rate means disregarding the changes in economic conditions after such an announcement. It seems important to communicate the basic rationale behind the conduct of monetary policy with regard to the economic situation of the time. This also applies to the discussion of inflation rate targeting. Japan not long ago experienced a period of some years of decline in consumer prices. At the time, there was an argument that all available monetary policy tools should be mobilized to achieve the rate of inflation that deemed desirable no matter what the reasons for the decline in prices were. On the other hand, there is an argument today that, confronted with an increase in prices, monetary policy should be conducted disregarding the effects of increases in energy and materials prices. Although there are complex mechanisms behind both increases and decreases in prices, it is an immovable objective of a central bank to assess the basic trend of price developments and achieve sustainable growth through long term stability in prices. If this is not fully understood, the targeted inflation rate will become its own goal and consequently makes the attainment of sustainable growth with price stability difficult. The recent enhancements to the communication strategy As discussed above, there are various issues in terms of improving central banks’ communication regarding monetary policy, many of which also apply to the Bank of Japan. With these in mind, the Bank has just gone over its communication strategy to enhance the framework which I described earlier. The first enhancement is to release the assessment from the "two perspectives" immediately after each Monetary Policy Meeting in the form of a statement. Although we have previously been releasing our basic understanding of the economic situation in the form of "The Bank's View" immediately after the meeting, communication regarding monetary policy had only been an announcement of the decision of "no change" in cases when there was no change in policy. Hereafter, following each meeting, whether or not there is a policy change, a summary of the assessment of the economic and price situation from the "two perspectives," and the Bank's thinking on the future conduct of monetary policy will be published along with the policy decision. Of course, even under the previous arrangements, the background for the policy decision and the thinking behind the conduct of monetary policy had been communicated very fully at the press conference after the Monetary Policy Meetings. However, from now on the main points will be communicated after each meeting in the form of a statement agreed upon by the Policy Board through discussion followed by a vote during the Monetary Policy Meeting. The second enhancement is to provide each quarter the forecasts of Policy Board members on the economic growth rate and the inflation rate, and the Risk Balance Charts. Various shocks are always impacting the economy, and there are times when the outlook for the economy and prices needs to be altered. However, if forecasts are revised frequently on the basis of every new item of economic data that becomes available, this will confuse the market. The Bank determined that quarterly publication of forecasts and the Risk Balance Charts is appropriate. What I must stress here is that forecast numbers and charts are references that supplement the qualitative descriptions in the Outlook Report and the statement that follows each meeting. It would be simple if economic forecasts, which form the basis of policy decisions, could be expressed in one or two figures, but this is not the case, as in all other central banks. The outlook for the economy and prices is too complicated to be expressed in quantitative forecasts and risks. In this sense, qualitative evaluation of the mechanisms behind changes in the economy and prices, and the risks of the deviation from the main scenario are important. In the Bank's publications, figures should always be read together with the written explanations to obtain a proper understanding. The third enhancement is to extend the forecast horizon for projections. The forecast horizon for projections in the Outlook Report published in April and October was for two fiscal years, the current and the next fiscal year. Starting from this October, however, the projections in the October Outlook Report will extend to the fiscal year after next. In the case of other central banks, shorter forecast horizons are 1 to 2 years but some extend to around 3 years. The Bank determined that in view of the transmission lag of monetary policy and the uncertainty in the economic outlook, it is appropriate to extend the forecast horizon as above. I have explained the recent enhancements to our communication strategy. Even if the framework of communication policy is adequate, what decides the quality of communication is the appropriateness of economic analysis and policy decisions. We will continue to make steady efforts to provide appropriate economic analyses, conduct monetary policy based on them, and communicate them carefully. Closing remarks In my remarks today, I have explained the situation of Japan's economy and the conduct of monetary policy, and also our views on central bank communication. My presentation today dealt mainly with monetary policy, but the Bank also plays an important role in an area that may be referred to as banking policy. In the United States, since last summer, the Federal Reserve has been undertaking various liquidity provision measures to maintain stability in the financial system. From our standpoint as a central bank that undertook unusual measures in the face of financial system turmoil from the 1990s, it is surprising that the Bank and the Federal Reserve adopted very similar ways of addressing the situation. Recalling that central banks are originally established to achieve stability in the financial system, however, this is no surprise. It is important for a central bank to actually grasp the situation of individual banks since it is providing credit for them. Also there are various issues regarding actual operation. Credit extension through cross-border collateral, which is currently being discussed among central banks, is one of them. We would like to contribute to the development of Japan's economy by utilizing the full range of functions of a central bank such as stabilizing the financial system and the payment system in addition to conducting monetary policy. Thank you very much for your kind attention.
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Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at a meeting with business leaders, Osaka, 25 August 2008.
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Masaaki Shirakawa: Recent economic and financial developments and the conduct of monetary policy Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at a meeting with business leaders, Osaka, 25 August 2008. * * * Introduction I am honored to be here today to speak and to exchange views with business leaders from the Kansai region. I have especially fond memories of the region because I taught as a professor at the Kyoto University School of Government for about two years before being appointed as the Governor of the Bank of Japan this spring. I would like to take this opportunity to express my deep gratitude for your cooperation with the Bank's branches in Osaka, Kobe, and Kyoto. Today, I will speak about issues facing Japan's economy and the Bank's thinking regarding the conduct of monetary policy. I. The current situation of Japan's economy First, I would like to discuss the current situation of Japan's economy. Since the beginning of 2002, the economy has enjoyed a moderate but prolonged period of economic expansion. Since the end of last year, however, the pace of economic growth has gradually slowed. Business fixed investment has been leveling off because the rise in energy and materials prices, which has accelerated since this spring, has depressed corporate profits. Private consumption has also been relatively weak due to the ongoing price rise, while growth in wages has remained sluggish. The pace of increase in exports has slowed, because of the effects of a slowdown in overseas economies. Given this situation, the Bank's assessment at the Monetary Policy Meeting held on August 18 and 19 was that Japan's economic growth has been sluggish. Prices, on the other hand, have been on the rise. The year-on-year rate of increase in the domestic corporate goods price index (CGPI) exceeded 7 percent in July due mainly to the rises in prices of steel and petroleum products. This was the highest rate of increase in 27 years, since 1981. The year-on-year rate of increase in the consumer price index (CPI) also rose in June to 1.9 percent. This was the highest rate in 15 years excluding fiscal 1997, when CPI inflation increased reflecting the rise in the rate of consumption tax. Japan currently faces a difficult situation given the sluggishness in the economy and the rise in prices. This situation has been caused by two factors: the surge in energy and materials prices; and the disruptions in global financial markets stemming from the U.S. subprime mortgage problem, and the slowdown in the global economy. II. The surge in energy and materials prices and Japan's economy First, I will address a topic related to the surge in energy and materials prices. A rise in such prices exerts downward pressure on Japan's economy, which depends heavily on imports of resources, through a decrease in purchasing power – an outflow of income. At the same time, it exerts upward pressure on prices. Let us look back on the two oil crises Japan previously faced. During the first oil crisis, crude oil prices surged from 3 U.S. dollars to 12 dollars per barrel – a fourfold rise – in a brief period between 1973 and 1974. During the second oil crisis, they surged from 15 dollars to 40 dollars between 1979 and 1980. Unlike these two cases, the current surge has been continuing over an extended period, which makes a comparison of the rise in oil prices difficult, since the extent of the increase differs depending on where one starts the calculation. If we start from 2002, when the level of oil prices was 21 dollars, the current level of 110-120 dollars – somewhat below the recent peak – is more than five times the level recorded in 2002. This means that the rise during the current phase has been the largest, even compared with the two oil crises. As a result, the size of the income outflow resulting from the surge in oil prices has also been the largest during the current phase: about 5 percent of real GDP, compared with about 3 percent during the two oil crises. Rises in crude oil prices, as well as the resultant outflows of income and decreases in production capacity, should be accepted as given conditions for Japan's economy. In other words, they cannot be avoided. However, economic and price developments differed markedly between the periods immediately after the two oil crises emerged. During the first oil crisis, Japan's economy suffered from a combination of runaway inflation and economic stagnation – in other words, stagflation. Economic indicators show that the economy, which continued enjoying rapid annual growth of 8-9 percent until 1973, suddenly contracted by 1 percent in 1974 and CPI inflation peaked at an annual rate of 25 percent in 1974. Contrarily, during the second oil crisis, the economy continued to grow at a rate of 3-5 percent and the CPI posted only a single-digit increase. At that time, CPI inflation exceeded 10 percent in the United States and 20 percent in the United Kingdom, and it can therefore be said that during the second oil crisis Japan's economy, together with the German economy, performed extremely well relative to other countries. What then made the difference in Japan's economic and price performances between the two oil crises? Of the various factors, two seem to be most important. The first factor was the difference in the economic and price situation immediately before the crises as well as the policy response. Just before the first oil crisis, there was an economic boom stemming partly from the government's plan for "remodeling the Japanese archipelago." The economy was overheated and the financial environment was overly accommodative, having increased the inflation expectations of households and firms. In fact, the rate of annual wage increases exceeded 20 percent in 1973. Against this background, a surge in crude oil prices increased inflation expectations further, making matters even worse. On the other hand, when the second oil crisis occurred, the economy was not overheated, the financial environment was not overly accommodative, and inflation expectations were restrained. In this situation, monetary tightening was initiated in a timely manner, and this kept inflation expectations low and thus succeeded in avoiding the so-called second-round effects – a rise in prices of non-petroleum goods and services triggered by a rise in crude oil prices. It was widely acknowledged that Japan's economy had successfully contained "homemade" inflation. The second factor was that Japan succeeded in transforming its economic structure while accepting the change in the relative-price structure due to the surge in crude oil prices. After the first oil crisis, Japanese firms pursued resource-saving production, and as a result, crude oil consumption per unit of output – the amount of crude oil used to produce a unit of value added – decreased in 1980 by 22 percent compared with the period of the first oil crisis. Meanwhile, Japanese firms made use of the change in the operating environment, seeking to develop energy-saving products such as small passenger cars, and this strengthened their international competitiveness. To put it another way, Japanese firms – which succeeded in transforming their production structure into one that was compatible with high crude oil prices, or with the new structure of relative prices – reacted positively to the change in the operating environment and created areas of comparative advantage. This contributed to overcoming the second oil crisis and to Japan's economic growth thereafter. The two factors I have just mentioned caused the large difference in economic developments between the two oil crises. The experience seems to clearly suggest policies necessary to cope with the current rise in crude oil prices. First, the second-round effects should be avoided so that inflation is contained within the rise in import costs and passing of the rise in import costs on to output prices. And second, it is crucial to promote a change in economic and industrial structures to make them compatible with the new structure of relative prices. It should, however, be noted that the current rise in crude oil prices has characteristics different from the past crises. In the current phase, global demand for crude oil has continued expanding over an extended period, and growth in demand from emerging economies has contributed in particular. On the other hand, in the past oil crises, supply constraints were the main cause of the rise in crude oil prices, rather than increases in demand. I will touch on such issues related to the difference in the background of price rises later when I discuss risks related to price developments. III. The U.S. subprime mortgage problem I will move on to the second factor causing sluggish growth in Japan's economy: the disruptions in global financial markets and the slowdown in the global economy. Roughly one year has passed since the U.S. subprime mortgage problem emerged, and the nature of this problem seems to have evolved over time. The first stage was the time of "liquidity constraints." Conduits and aggregators of securitized products including those backed by subprime mortgages faced difficulties in raising funds from the market, as a result of large declines in the prices of such products. Financial institutions' liquidity demand grew considerably to provide the conduits and aggregators with liquidity, and this exerted strong upward pressure on interest rates in U.S. and European money markets, where financial institutions borrow and lend funds. In reaction to the liquidity constraints and the surge in money market rates, central banks have strived to ensure market stability by devising various measures, for example, extending the term of liquidity provisions and widening the range of counterparties and collaterals. As the money markets gradually moved closer toward stability, the second stage emerged: the time of "credit contraction," which began in early 2008. The declines in the prices of securitized products increased financial institutions' losses and reduced their capital bases; consequently, financial institutions have tightened their credit standards and their lending attitudes. This has exerted strong downward pressure on the economy. Most recently, a third stage has emerged. In this stage, delinquency rates of not only subprime-related products but also commercial real estate loans and consumer loans have been rising reflecting the sluggishness in the U.S. economy. As a result, a situation in which the sluggishness in the economy causes financial institutions' asset quality to deteriorate further – with further adverse impact on the economy – is becoming a cause for concern. To put it another way, at the third stage there are concerns about a negative feedback loop between financial markets, asset prices, and economic activity. Many discussions have taken place on what kinds of lessons can be drawn from the U.S. subprime mortgage problem. Since the nature and background of the problem are complex, I hesitate to draw lessons prematurely. It might be argued that the cause of the problem was investors' and financial institutions' lax risk management. This observation seems to me accurate, but it would not be true to say there were no warning signs about the accumulation of risks. We must therefore pursue the reason why many market participants made the mistakes that eventually led to the problem despite the warning signs. Although solutions at this point have yet to fully emerge, several major issues – although not completely new – seem again to have come to the fore. Looking back at previous bubbles in financial activities and asset prices, including Japan's asset price bubble, we can see that many have occurred following a period of price stability and continued low interest rates. In the current phase too, investors and financial institutions eased their credit standards and increased dependence on loans or leverage, accelerating their "search for yield" through investment in, for example, securitized products. Underlying this situation were excessively accommodative financial conditions and credit expansion on a global scale – amid a prolonged period of economic growth and low inflation. On the other hand, when bubbles burst, capital bases of financial institutions are impaired and the period of credit contraction begins, depressing economic activity and constraining the transmission of monetary policy. Similar to cases when bubbles emerge, the current U.S. subprime mortgage problem keenly illustrates that it is difficult to recognize the bursting of a bubble as it happens. Central banks should therefore pay due attention, in their conduct of monetary policy, to the negative effects that may arise from prolonged accommodative financial conditions. Let me bring the topic back to the future course of the global economy. As described earlier, with regard to the U.S. economy, it is unforeseeable when and how the negative feedback loop between financial markets, asset prices, and economic activity will diminish. In Europe, economic growth is slowing further. In Asia, although the Chinese and Indian economies continue to post high growth, some of the NIEs and ASEAN economies are showing deceleration in exports and signs of slowing domestic demand. Developments in the global economy as a whole are therefore likely to remain highly uncertain for the time being. IV. The outlook for Japan's economy and the conduct of monetary policy In view of the two problems I have discussed, I would now like to talk about the outlook for Japan's economy and the Bank's conduct of monetary policy. The Bank's main scenario is as follows: growth will likely remain sluggish for the time being against the backdrop of high energy and materials prices and weaker growth in exports due to a slowdown in overseas economies; however, Japan's economy is unlikely to experience a deep adjustment phase. Let me explain the thinking behind this projection. First, as a result of firms' restructuring efforts, which continued in the 1990s up until recently, the "three excesses" – namely, in production capacity, employment, and debt – have been eliminated, and Japan's economy has become more resilient to shocks that weaken economic growth. Second, losses incurred by Japanese financial institutions due to the subprime mortgage problem are limited compared to those of U.S. and European financial institutions and Japanese financial markets continue to be stable, which suggests that the functioning of the financial system remains intact. And third, Japan's financial conditions have been accommodative. Although it is a cause for concern that financing conditions of firms in construction and real estate industries and small firms in general are becoming increasingly severe, financial conditions taken as a whole have been accommodative. The short-term real interest rate calculated by subtracting the CPI inflation rate from the call rate has been negative, as the policy interest rate – the uncollateralized overnight call rate – has been at a low level of 0.5 percent. Firms' financing costs have also remained low. This accommodative environment for corporate finance is expected to continue to support business activity. Because of this, it is reasonable to expect, as the main scenario, that Japan's economy will return gradually to a moderate growth path as commodity prices level out and overseas economies move out of their deceleration phase. Regarding the outlook for prices, it is unlikely that the second-round effects will intensify in the near term, judging from the current level of the domestic output gap, the inflation expectations of households, and firms' price-setting behavior. Developments in wages are one of the important indicators pointing to the emergence of second-round effects, and so far wage growth has been relatively weak. The rate of increase in consumer prices will likely rise slightly over the coming months, since the pass-through of earlier increases in import prices is expected to continue for a while. Thereafter, however, the rate of increase is expected to decline gradually in line with the expected moderation in the rises in international commodity prices and the resultant subsiding of firms' raising of sales prices. Economic forecasts often differ. Economic forecasters, including central banks, do their utmost to provide accurate projections of economic activity and prices, but projection errors are often sizable. In view of that, it is very important for the Bank to carefully consider the most likely outlook, the main scenario, as well as various factors causing uncertainty in making economic projections, which are the basis for the conduct of monetary policy. It is also important for the Bank to not take any predetermined view, but to maintain an openminded stance when it examines incoming data and to revise its projections as necessary. Let me move now to a discussion of risk factors. Global financial markets, which I mentioned earlier, are likely to remain unstable for the time being, and there are downside risks to the world economy. Regarding the outlook for Japan's economy, there is a risk that domestic demand may weaken as a result of the outflow of income due to the high energy and materials prices. The Bank is therefore attentive to the downside risks to economic growth, although the economy does not face the need to adjust production capacity and employment. As for prices, the Bank is focusing on the upside risks to inflation. Energy and materials prices have been rising for a long time due to the aforementioned worldwide growth in demand, especially demand from emerging economies, in addition to factors pertaining to supply constraints. Therefore, this rise should not be regarded as temporary. Given the trend increases in energy and materials prices and the fact that Japan's economy has not faced such a high level of inflation in recent years, the Bank should pay attention to the risk that possible changes in the inflation expectations of households and firms' price-setting behavior may generate second-round effects. As I have explained, the current situation requires the Bank to carefully monitor both downside risks to economic growth and upside risks to inflation. Furthermore, if the downside risks to the economy turn out to decrease, there is a risk that prolonging the period of accommodative financial conditions will lead to swings in economic activity and prices. The Bank continues to carefully assess the future outlook for economic activity and prices, closely considering the likelihood of its projections as well as factors posing upside or downside risks, and will implement its policies in a flexible manner. Moreover, since global financial markets are expected to remain unstable and there are various uncertainties in the outlook for economic activity and prices, it is essential for the Bank to ensure the stability of the Japanese financial markets. Closing remarks As I have so far explained, the current state of Japan's economy and the world economy pose an extremely difficult situation for the conduct of monetary policy. While monetary policy is expected to contribute to sustainable economic growth by creating a stable financial and economic environment, it cannot by itself increase the potential growth rate of the economy. A prerequisite for the economy to boost its growth potential is a rise in productivity, facilitated by innovation and a continual review of resource allocation. The Kansai region is famous for its long history of pioneering entrepreneurship, as demonstrated by the fact that the world's first futures trading was carried out at the Dojima rice exchange in Osaka during the Edo Period (1603-1867). In the current environment, I look forward to seeing the region's originality and inventiveness add to the vigor of Japan's economy. For our part, we will continue to support your efforts through our conduct of monetary policy. I would like to close my speech by mentioning an early episode in the relationship between the business community of the Kansai region and the Bank of Japan. The Bank was established in 1882 with capital of 10 million yen – equivalent to approximately 30 billion yen today. Of the contribution to the Bank's capital from the private sector, which accounted for half of the total, about 60 percent of the shareholders and 48 percent of the amount came from the Kansai region. In other words, the business community of the Kansai region contributed significantly to the establishment of Japan's central banking system, which underpins the market economy. Thank you very much for your kind attention.
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Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Graduate School of Economics of Nagoya University, Nagoya, 2 September 2008.
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Masaaki Shirakawa: Technological innovation and central banks Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Graduate School of Economics of Nagoya University, Nagoya, 2 September 2008. * * * Introduction I am very honored to have the opportunity to speak here at the Graduate School of Economics of Nagoya University. My speech today deals with the topic of technological innovation and central banks. The choice of the topic is influenced in part by the fact that Nagoya is known as a center of manufacturing and technological innovation. Another reason is that, for central banks to make appropriate policy judgments, it is increasingly important to take account of changes brought about by technological innovation and to actively take advantage of such innovation. I. Functions and business operations of a central bank A. Functions of a central bank Before discussing the topic of technological innovation, let me first provide you with an overview of central bank functions. The term "central bank" will probably remind you of banknote issuance. Textbooks on macroeconomics and banking and finance describe central banking operations such as the conduct of monetary policy and the "lender of last resort" function. This may raise the questions of why a single institution, a central bank, is responsible for these wide-ranging activities, and also why a bank, instead of a government office, is responsible for them. To find the answers to these questions, we should first understand that issuing money, or banknotes to be precise, is the most fundamental function of a central bank. The Bank of England, one of the oldest central banks in the world, was established in 1694 as a private bank. In those days, banknotes were issued by several private banks. However, through competition among banks, the function of issuing banknotes was gradually monopolized by the Bank of England. In 1844, it was legislated that the Bank of England be the sole issuer of banknotes, and it gradually established itself as a present-day central bank. Similarly in Japan, private banks issued their own banknotes in the early Meiji Period (around 1870). But to solve the complexities involved in having multiple currencies, the Bank of Japan was established in 1882 as the only institution to issue banknotes. As history shows, the most basic central bank function is to issue banknotes, which are recorded as its liabilities. To enable the public to use with confidence and convenience the banknotes it issues, public confidence in the currency must be secured. And to secure such confidence, the following two conditions must be met. First, circulation of the currency and the functioning of the settlement and financial systems that support it must be reliable and efficient. The "lender of last resort" function that I mentioned at the beginning is one of the functions of a central bank to maintain financial system stability. Second, the value of the currency must be stable, that is, price stability must be maintained. A central bank conducts monetary policy to fulfill this condition. As I have discussed thus far, various central banking operations work to secure public confidence in the currency, with the function of banknote issuance as the starting point. As I will describe in greater detail later, these central banking operations are carried out through banking activities. B. Central banking operations 1. Provision of cash and settlement services Chart 1 Settlement via Bank of Japan (BOJ) Current Accounts Individual X Goods/Services Firm Y Deposits Withdrawals X’s Account Y’s Account Bank A Bank B Deposits Bank A’s Current Account Withdrawals Funds transfer Bank B’s Current Account BOJ Let me explain central banking operations in detail. I will start with the central banking operations of supplying cash and providing settlement services. The Bank, through its network consisting of the Head Office, branches, and local offices, arranges that cash is circulated throughout the country. In addition to cash, the Bank provides current accounts to private financial institutions, whose balances can be exchanged for banknotes at any time (Chart 1). Just as in the case of an individual holding an account with a private bank and obtaining loans, private banks and securities companies hold current accounts with the Bank and borrow funds from the Bank. Many of you may pay utility bills or pay for items you purchased by using funds transfer or remittances through private banks. Banks that receive such requests settle these payments among themselves by transferring funds via their current accounts with the Bank. The amount of funds settled via the current accounts with the Bank is increasing steadily and currently totals around 120 trillion yen per business day (Chart 2). Moreover, the amount of funds settled also fluctuates very much within a day. For the efficiency and safety of such settlement via the Bank's current account, the Bank operates a computer network system called the Bank of Japan Financial Network System, or BOJ-NET for short. Let us now see how a central bank supplies funds (Chart 3). When the Bank extends loans to financial institutions or buys securities such as Japanese government bonds (JGBs) from them, funds are credited to these institutions' current account with the Bank. Such operations are called "funds-supplying operations." When cash becomes necessary at these institutions to meet customers' withdrawals, financial institutions obtain cash by withdrawing deposits from their current account with the Bank. This is the overall picture how cash is put into circulation. These funds-supplying processes can be outlined and explained by changes in the balance sheet of the Bank (Chart 3). When the Bank, as in the example I have just given, supplies funds by extending loans to financial institutions or buying JGBs, such loans or JGBs represent an increase in its "assets." At the same time, though, the funds thus supplied represent an increase in its "liabilities," while for the financial institutions they represent an increase in their "assets" in the form of increased current account deposits with the Bank or banknotes. What should be stressed here is that the money is supplied through the banking activities of the central bank, in other words, the execution of transactions as a bank. Chart 2 Value Settled via BOJ Current Accounts Average Daily Value Settled tril. yen tril. yen Distribution of Value Settled on June 30, 2008 9:00 Note: Data for 2008 are the average for the January-July 2008 period. 11:00 13:00 17:00 15:00 Note: Value settled in each ten-minute period. Chart 3 Funds-Supplying Operation by the BOJ Supply of 30 billion yen by the BOJ through outright purchase of Japanese government bonds (JGBs) 30 billion yen in cash Bank A BOJ JGBs worth 30 billion yen Bank A’s balance sheet BOJ’s balance sheet (Assets) bil. yen JGBs 0 (Liabilities) bil. yen BOJ current account 0 (Assets) (Liabilities) BOJ current account 0 JGBs Withdrawal of 10 billion yen by Bank A from BOJ current account after the operation BOJ’s balance sheet bil. yen (Assets) JGBs Bank A’s balance sheet (Liabilities) Banknotes bil. yen BOJ current account 30 (Assets) (Liabilities) Banknotes BOJ current account 30 JGBs 2. Maintenance of financial system stability I would now like to discuss the second item on my list of central banking operations, which is the maintenance of financial system stability. As I mentioned earlier, means of payment familiar to households and firms, besides cash, include funds transfers between bank accounts. A part of private bank deposits, such as ordinary deposits, is also called "deposit money," and they function as currency based on the assurance that such deposits can be exchanged for banknotes issued by the Bank at any time. Before proceeding further, let me briefly define terms such as "cash" and "money," since they have been used so far without a strict definition (Chart 4). "Cash," which consists of Bank of Japan notes and coins in circulation, amounts to around 80 trillion yen. The sum of current account balances at the Bank and Bank of Japan notes in circulation is called "central bank money." The amount of "deposit money" such as demand deposits held by households and firms is around 400 trillion yen, significantly larger than the outstanding amount of cash. Money stock, which is the total of cash, deposit money, and "quasi-money" such as time deposits, all held by households and firms, is around 1,000 trillion yen. Chart 4 Classification of “Money” Central Bank Money (yen, average amounts outstanding in July 2008) BOJ Current Account Balances Monetary Base 87.9 tril. 7.6 tril. Bank of Japan Notes in Circulation 75.7 tril. Coins in Circulation 4.5 tril. ---------------------------------------------------------------Total: Cash in Circulation 80.2 tril. Deposit Money* Demand Deposits, etc. 408.5 tril. Time Deposits, etc. 534.2 tril. Quasi-Money* ---------------------------------------------------------------Total: Private Bank Deposits* 966.5 tril. Nominal GDP of Japan in fiscal 2007: 515 tril. yen Money Stock* (M3) 1,038.7 tril. * Deposits of financial institutions and the central government are not included. The present-day currency system is built on a complex network consisting of the central bank, financial institutions that provide deposit money, and financial markets where financial institutions carry out their activities. Therefore, to secure the ease of use of money and its value, maintenance of financial system stability – the stable functioning of financial institutions and financial markets – is essential. Failure of one financial institution to meet its payment obligations may lead to problems for other financial institutions that had been expecting the transfer of funds from the troubled institution, and this may lead to a chain reaction of defaults, that is, the materialization of "systemic risk." In order to prevent the materialization of such systemic risk, central banks may temporarily extend necessary funds to financial institutions facing funds shortages. This is called the "lender of last resort" function of the central bank. In the period from the latter half of the 1990s to the early 2000s, when Japan's financial system was in turmoil, the Bank extended such emergency loans, the so-called Nichigin Tokuyu, to financial institutions. This is an example of the central bank assuming the role of lender of last resort. In addition, to prevent the materialization of systemic risk, central banks should always monitor whether activities of financial institutions and the functioning of the payment and settlement system are sound, and provide advice as necessary. To this end, the Bank is continually monitoring the situation in financial institutions and in financial markets. The Bank also conducts on-site examinations of financial institutions, in which the Bank's staff visit the premises of these institutions to examine in detail their financial soundness and risk management. 3. Conduct of monetary policy The last item on my list of central banking operations is the conduct of monetary policy, which aims at maintaining stability in the value of the currency, in other words, at maintaining price stability. Central banks maintain price stability through controlling the amount of currency they supply and the level of interest rates, that is, the price of money. If the Bank supplies abundant funds to the market, the market interest rate – the uncollateralized overnight call rate – will decline, reducing the funding costs of financial institutions. This will influence other interest rates such as those on loans to households and firms. Through the change in interest rates, the cost of funds necessary for the economic activities of firms and households will change, and this will stimulate overall economic activity. As a result, this will alter the economy's supply and demand balance of goods and services, and will in turn affect prices. Monetary policy is not enforced by legislation or through administrative discretion. Rather, as I have explained, it is conducted through the central bank's banking operations, with private financial institutions as its counterparts. As we have seen so far, the various roles played by the central bank are conducted through its banking operations, and this is the very reason why they are undertaken by a bank instead of a government office. II. Technological innovation and the Bank of Japan A. Changes brought about by technological innovation Central bank functions, which we have just looked at, have differed from country to country and from time to time, but are now well established in the major countries. However, the specifics of central banking operations enabling central banks to fulfill their role have been changing continually. Especially in recent years, the environment surrounding central banks has altered significantly and rapidly through economic globalization, the globalization of financial markets, and advances in financial engineering techniques such as those in the field of derivatives. These changes have been driven by technological innovation particularly in information and communications technology. In view of such changes in the environment, the Bank has been making efforts to properly conduct central banking operations that proactively pursue the achievement of its mission. Let me introduce to you the efforts that the Bank has been making with regard to its three central banking operations that I described earlier. B. Technological innovation and central banking operations 1. Provision of cash and settlement services My first topic with respect to central banking operations is the provision of cash and settlement services. a. Provision of cash What is most important in securing the public's confidence in the use of money is to ensure their confidence in cash. The issuance of paper money, that is, of banknotes, in itself is the result of technological innovation. The oldest paper money in Japan is said to be the Yamada Hagaki, which was circulated near Nagoya, in the Ise Yamada area (now Ise City, Mie Prefecture) around the 1600s [References 1 and 2]. The history of paper money can also be said to be the history of anti-counterfeiting, and at the Bank we continually examine the authenticity of cash and carry out research and development on anti-counterfeiting technologies. Banknote counterfeiting increased rapidly in the 2000s: the annual number of counterfeit notes detected surged from previously several hundreds to approximately 26,000 in 2004. This is due to the wider use of digital imaging devices such as color copiers and printers, and counterfeit notes have become even more sophisticated with the further technological development of such devices. Technological innovation is partly responsible for the increase in counterfeit banknotes, but at the same time it also contributes to providing anti-counterfeiting measures. Banknotes incorporate many security features such as meticulous designs, watermarks, and luminescent ink that prevents the reproduction by color copiers or similar devices. The new series banknotes issued since 2004 are equipped with state-of-the-art security features (Chart 5) [References 3 and 4]: one is a hologram at the lower left corner of 5,000 and 10,000 yen notes, which changes its color and pattern when the notes are tilted. Another feature is intaglio printing, and the ink on the new series notes is raised higher than the ink on the previous ones. The number of counterfeit banknotes has clearly decreased due to the issuance of the new series notes equipped with such high security features. Only one out of one million banknotes in circulation is counterfeit in Japan, which is very low compared to one out of 10 thousand in the United States. This is attributable to the high sophistication of banknote production technologies in Japan. However, the Bank needs to make persistent efforts to deal with the rapid progress in technologies that make counterfeiting possible. Given the globalization of currency counterfeiting, the Bank has been conducting joint research on anti-counterfeit technologies with other central banks, law enforcement agencies, and manufacturers of cash handling machines. Chart 5 Security Features of the Bank of Japan Notes Security Features of 10,000 Yen Note Pearl ink When viewed from different angles, a semi-transparent pattern printed with pink pearl ink appears in the blank areas of the left and right margins of the front of the note. Luminescent ink The Governor’s seal on the front side and some parts of the background pattern fluoresce under ultraviolet light. Intaglio printing Raised printing is used for some features of the note. Hologram When the banknote is tilted, the color and pattern of the design change. Latent image When the banknote is viewed from a certain angle, the number “10000” appears on the bottom left of the front side, and the word “Nippon” on the top right of the back side. Watermark-bar-pattern When the banknote is held up to the light, three vertical watermark bars become visible. This feature is more difficult to reproduce with personal computers or color copiers than the traditional watermark. Various types of electronic money have been introduced and used as a new means of retail payment. However, these types of electronic money cannot immediately replace cash in terms of general acceptability and anonymity, both of which are characteristics of cash, as evidenced by the fact that their use is restricted mainly to small-value retail payments and closed networks. A recent survey conducted by the Bank shows that the outstanding value of electronic money is approximately 77 billion yen, equivalent to only 0.1 percent of the outstanding value of cash (notes and coins) and 1.7 percent of that of coins [Reference 5]. With the recent rapid increase in its use, however, electronic money seems to have become widely established as a means of small-value payments. The Bank has been working on research and analysis on electronic money, paying due attention to how such a new means of payment will change the concept of money and the design of payment and settlement systems, and how these changes may affect the Bank's policy and business operations in the future. In addition, the Bank, as the secretariat of Japan for the Technical Committee for Financial Services of the International Organization for Standardization (ISO), participates in the standardization of information security technologies such as cryptography and biometrics, and the coding of message transmissions among financial institutions. Making use of the results of these efforts, the Bank supports Japan's financial industry to take advantage of new information technologies. b. Enhancement of settlement services Reflecting the progress in information processing technology and the increase in financial institutions' need for more advanced settlement services, the Bank has also been working to improve the safety and efficiency of settlement via current accounts at the Bank, which is another means of settlement the Bank offers. I will briefly explain the history of large-value interbank funds settlement as a good example of how technological innovation has contributed to the evolution of financial transactions. Most central banks, including the Bank of Japan, used to conduct interbank settlements on a net basis at designated times during the day. The settlements between private financial institutions are completed by transferring funds between current accounts that they hold with the Bank. In this settlement mode, called "designated-time net settlement," funds transfers were made at designated times of the day, four times per day in Japan. At each designated time, the net settlement position of each financial institution was calculated simultaneously and its account at the Bank was credited or debited. With this settlement mode, financial institutions need only the funds equivalent to their net debit positions at the time of settlement, and thus, it is an efficient mode from the viewpoint of the management of liquidity and business operations. Under this mode, however, if a single financial institution in the system were to fail to meet its obligations, all payments would inevitably be suspended. In the worst case, this would lead to a chain of defaults at financial institutions. Since the total daily value of settlement via the current accounts at the Bank is substantial, reaching around 120 trillion yen, the effects of this risk could be grave. In order to reduce such risk, in 2001, the Bank converted the designated-time net settlement to a settlement mode in which funds transfers are made immediately and individually. This mode is called "real-time gross settlement (RTGS)." In RTGS, each payment instruction sent by financial institutions for a funds transfer through current accounts at the Bank is settled immediately and individually upon receipt. Therefore, negative effects of one financial institution's failure to pay would be limited to counterparties to that institution and would be minimized for other institutions and the overall settlement system. While this is a considerable advantage, there is an issue specific to RTGS that need to be addressed. Namely, it requires financial institutions to prepare larger amounts of intraday liquidity for settlement compared with the designated-time net settlement. In the current RTGS mode, if each and every financial institution holds back its payments until it receives payments from others, there is a possibility that all system participants would end up short of funds and settlements would not be processed (Chart 6). If such behavior became widespread, it could lead to gridlock, and smooth settlement, the aim of RTGS, would not be achieved. The breakthrough in addressing this issue was the substantial progress in information processing technology. The Bank has been working on the implementation of the nextgeneration RTGS (RTGS-XG) project, and is planning to introduce new functions, "queuing and offsetting mechanisms," into the BOJ-NET Funds Transfer System in October 2008 [Reference 6]. The "queuing mechanism" will place payment instructions in the BOJ-NET central queue. The "offsetting mechanism" will then identify sets of payment instructions in the queue that can be offset simultaneously and settle these individually, as in RTGS. The "offsetting mechanism" will carry out bilateral offsettings continuously throughout the day, and multilateral offsettings four times a day. The RTGS-XG project, therefore, aims to achieve efficient settlement by maintaining the advantage of the RTGS mode, its stability, while reducing the liquidity necessary for settlement. The results of running tests of RTGSXG, in which many financial institutions participated, show that the aim of the project, that is, improving the efficiency of settlement and minimizing the liquidity necessary for settlement, will be achieved with the introduction of the above mechanisms (Chart 7). RTGS-XG was made possible with the increase in information processing capacity, and this is a good example of how technological innovation has contributed to improving the safety and efficiency of financial transactions. Chart 6 Gridlock in the BOJ-NET RTGS System Current BOJ-NET RTGS System - In order to send a payment instruction, each bank needs to have a sufficient balance in its BOJ current account. Payment instruction - All three banks in this example do not have sufficient balances. Bank A Balance: 10 Bank B Balance: 0 - If each bank waits for the other to pay first, gridlock occurs, and none of the payment instructions will be settled. New BOJ-NET RTGS System Bank C Balance: 20 - If a bank does not have a sufficient balance in its BOJ current account, the payment instruction will be stored in a centralized queue. - The system will identify sets of payment instructions in the queue that can be settled when taking into account incoming payments as a source of liquidity, and will settle them simultaneously. - Gridlock will not occur in this example, because payment instructions will be settled simultaneously. Chart 7 Safety and Efficiency Achieved under the New BOJ-NET RTGS System Value-weighted average time of settlement 12:30 Low Curve AB shows the possible combinations of total required balances and average settlement times under the new BOJ-NET RTGS system A Combination achieved on May 12, 2008 under the current BOJ-NET RTGS system 12:00 Safety 11:30 11:00 High Combination achieved in the running test for the new BOJ-NET RTGS system B 10:30 High Efficiency Low Value of total balances required to settle payments on a given day (tril. yen) Note: Under the new BOJ-NET RTGS system, payments that are currently cleared in the Foreign Exchange Yen Clearing System and settled at 14:30 on a net basis in the current BOJ-NET RTGS system will be settled on a gross basis. 2. Maintenance of financial system stability Technological innovation has also posed a great challenge to central banks' efforts to maintain financial system stability. Advances in information processing have facilitated financial innovation and created new financial instruments such as derivatives and securitized products. These have enabled financial institutions to unbundle and reallocate risks of various kinds, such as credit and interest rate risks, based on diverse and complex methods for analyzing and managing risks. Let us take securitization of mortgages, the root of the U.S. subprime mortgage problem, as an example. Mortgages involve various risks. For instance, a lender or an investor may face credit risk, the risk of loss resulting from the counterparty's failure to perform its financial obligations, as well as interest rate risk, the risk of loss from a rise in interest rates during the loan term. Needless to say, regular bank loans entail similar risks; however, mortgages present larger risks due to their extremely long maturity, and the risk management of mortgages is more difficult. Securitization is an example of the enhancement of risk management techniques achieved through advances in information processing. When mortgages are securitized, a number of mortgages are packaged together and securities backed by these mortgages (mortgage-backed securities, [MBSs]) are issued (Chart 8). Because interest payments on, and redemptions of, the securities are covered by the payments of interest and principal on a large number of mortgages, there is a greater diversification of risk when compared with individual mortgages. For example, creating MBSs by packaging a number of mortgages whose borrowers are scattered over a wide geographical area can diversify risks, such as the catastrophe risk associated with a particular area, and risk quantification becomes easier because of the law of large numbers. Securitization also allows financial institutions to restructure the packaged mortgages into multiple securitized products with different risk profiles that meet specific investor needs with various degrees of risk acceptance and preference and to sell these products. What is more, as the financial intermediary function of the mortgage market becomes more efficient through these schemes, there are greater opportunities for borrowers to obtain mortgages on favorable terms. Chart 8 Securitization of Mortgages Securitized Product A Mortgage 1 Mortgage 2 Mortgage 3 Investor V Investor W Issuer Securitized Product B Investor X Mortgage 4 Mortgage 5 . . . A large number of mortgages are packaged to diversify risks. Securitized Product C Securitized Product D Investor Y Investor Z Securitized products are created by unbundling and reallocating cash flows and risks. On the other hand, if we fail to properly understand new financial engineering techniques, this will lead to a failure in risk management. For example, even when a securitized product is backed by a large number of mortgages for the purpose of risk diversification, the law of large numbers will not work if the economy as a whole is experiencing a housing bubble and the individual loans backing such securities as a result take on similar risk profiles. Global financial markets have been in turmoil stemming from the U.S. subprime mortgage problem since summer 2007, and one of the causes was the excessive risk-taking arising from the false assessment of such risks amid the rapid expansion of the market for securitized products. I hasten to add, however, that just blaming securitization will not solve the problem. Providing financial services is difficult, and this can be understood if you put yourself in the position of mortgage loan suppliers. For an economy to prosper, someone has to provide credit while managing the risks involved, namely, the credit, interest rate, and liquidity risks. Just like manufacturing, the provision of financial services requires specialized skills, and financial institutions need to adapt their services to changes in the financial environment. At the same time, central banks and supervisory authorities around the world face new challenges in their quest to maintain the financial system stability as a result of such changes in the financial environment. While such challenges span various areas, a key prerequisite is a proper understanding of the risks involved in individual financial transactions. In this regard, the Bank has been conducting surveys and research on ways to properly assess and analyze the risks involved in new financial engineering techniques and financial instruments, and has made use of the findings in its market monitoring and discussions with financial institutions in on-site examinations. At the same time, it is important to identify risks in the financial system as a whole in a cross-sectoral manner. These are indeed very extensive and difficult issues, and central banks and supervisory authorities around the world have been deliberating on how to improve financial regulation and supervision by making use of the lessons learned from the U.S. subprime mortgage problem. 3. Issues regarding the conduct of monetary policy I will now move on to the last topic in the area of central banking operations, the conduct of monetary policy, which covers a wide range of issues. Today, I will focus on two of them: first, how the Bank makes use of the fruits of technological innovation in the development of monetary policy tools; and second, what challenges technological innovation poses concerning the Bank's assessment of the economic and price situation. a. Advancement of monetary policy tools Let me begin with changes in the ways in which the Bank supplies funds to financial institutions by extending loans and executing money market operations. Currently, the whole process of the Bank's funds-supplying operations, involving notification by the Bank of such operations, financial institutions' application for such operations, the transfer of funds to financial institutions' current accounts at the Bank, and their repayment of funds to the Bank, are executed electronically. Swift processing of transactions and settlements is essential as prices in financial markets change by the second in response to various news, and the Bank's processing system is now an indispensable infrastructure for conducting money market operations flexibly so as to maintain stability in financial markets. Financial institutions put up collateral when they receive loans from the Bank, and the management of such collateral has been carried out under an integrated online system called the "pooled collateral" system since 2001. The system made possible a more efficient use of collateral by financial institutions and improved significantly the administration of collateral by the Bank and financial institutions. The Bank started to accept, in addition to conventional financial assets such as JGBs and corporate bonds, new, innovative financial assets, such as securitized products and dematerialized commercial paper, as collateral from financial institutions. These changes are technological innovations in monetary policy tools, achieved through the progress in information processing and financial engineering. b. Challenges with respect to the assessment of the economic and price situation Next, I will discuss the last issue, the challenges technological innovation poses regarding the assessment of the economic and price situation, which forms the basis for the appropriate conduct of monetary policy by the Bank. Monetary policy aims to contribute to the sustainable growth of the economy through the maintenance of price stability. Technological innovation raises practical issues when an accurate measurement of the price level using price indexes, such as the consumer price index and the corporate goods price index, becomes difficult as a result of technological progress itself. Let me explain this issue from three aspects. First of all, to grasp price developments accurately, new products and services, continuously introduced as the fruit of technological innovation, need to be incorporated swiftly among the items comprising these price indexes. Second, quality improvements need to be considered when measuring prices. The quality of a product improves with technological innovation, but often its price is kept unchanged, and this can be taken as a price decline in real terms. Price indexes take this point into account, but it is difficult to assess quality improvements and to what extent this should be considered as a change in prices. Let me take computers as an example. Statistically, an increase in memory capacity is regarded as a decline in price. From a consumer's viewpoint, however, it is difficult to judge whether the increase in memory capacity should be regarded as a reduction in the price of computers, because this assessment will depend on the consumer's individual taste and requirements of a computer. And third, identifying the most typical sample price for a good or service has become more difficult with the progress in technological innovation. For example, recently, there have been an increasing number of services that award benefits to the customer after certain conditions are satisfied, such as loyalty cards and mileage services. These are examples of so-called "nonlinear pricing" systems. As a result of such highly distinct price setting, a particular good or service has various prices, making it difficult to determine the most typical sample price for each item when compiling price indexes. Effects of technological innovation are also significant in the assessment of economic activity. Measurement of real GDP or productivity is based on the assumption that nominal values can be broken down accurately into price and volume. Naturally, however, if price measurement through indexes becomes difficult, it is also difficult to assess volumes. In addition to these measurement problems, there are also difficult conceptual problems. For example, making judgments with regard to what effects technological innovation is having on productivity in the overall economy, in other words, the potential growth rate, is crucial in assessing the tightness of supply and demand conditions, the so-called output gap. Let me take an example to illustrate this point. Beginning in the early 1990s, the U.S. economy experienced a long phase of expansion and the unemployment rate fell significantly, while prices remained stable. It has often been argued that this expansion was attributable to a rise in productivity brought about by the IT revolution heralding the arrival of the so-called "new economy." Under such circumstances, a central bank should examine carefully whether productivity of the economy is indeed rising, because if productivity growth is real, the central bank should not raise interest rates unnecessarily so as not to hamper the opportunity for economic growth. On the other hand, if productivity growth is overestimated, the central bank might miss the opportunity to implementing a necessary raise in interest rates, and as a result, inflation or an economic bubble might occur. For this reason, it is essential that, in its conduct of monetary policy, the Bank grasps accurately developments in productivity. Closing remarks As I have discussed, technological innovation is ongoing, and just as for private firms and financial institutions, the environment in which central banks operate is continuously changing. I would like to close my speech by noting a few points that I believe to be important for central banks in confronting these changes. First, central banks must strive to clearly understand changes in the environment and make constant efforts to review their operations. Central banks are decidedly practical institutions that perform banking operations. As I said at the outset, in order to enable the public to use money with confidence and convenience, central banks must strive to provide high-quality central banking services by making full use of the fruits of technological innovation. Although monetary policy does not directly contribute to raising the productivity of the economy, central banks' banking services, such as settlement, do. Second, technological innovation may bring about various uncertainties regarding the assessment of the economic and price situation as well as the conduct of monetary policy on the basis of such assessment. In order to make appropriate policy decisions under such circumstances, central banks must continuously improve information gathering methods and analytical tools. Looking back at cases both in Japan and abroad where central banks were accused of making monetary policy mistakes, such mistakes arose when the central bank failed to properly understand major changes in the environment and their significance. With regard to both of these points, central banks must continue to make efforts to continually grasp changes in the environment surrounding them and examine their actions in light of these changes. That is to say, central banks must constantly be willing to learn. It is my belief that to this end, interaction between theoretical research in academia and our practical experience plays an important role. Of course, I understand that the standpoint of an academic and that of a policymaker differ. For an academic, what is important is to present new points of view and be prepared to examine the persuasiveness of his or her theories. And on occasion, it may be necessary to propose bold hypotheses or interpretations. Good theories are likely to be those that, as the result of such efforts, have stood the test of time. In contrast, a policymaker cannot wait until a theory regarding a particular issue has been confirmed, nor can he or she put all eggs in one basket and embark on an untested policy course. A policymaker must make use of the various theories available at the time in making judgments and must sometimes deal with situations where conventional theories do not apply. For this reason, a policymaker must be willing to continue to learn and take every opportunity to exchange views and opinions with academics. At the same time, there may be cases where issues faced by central banks and their experiences may offer new perspectives for academic research. Therefore, it is important that academics and policymakers recognize the differences of their roles and respect each other's work. I think it is this interaction between theory and practice that will stimulate further evolution in central banking operations. I hope my speech today will serve to facilitate this interaction. Thank you very much for your attention. References [1] Mari Ohnuki, "Yamada Hagaki, Japan's First Paper Money," Monetary and Economic Studies, 17 (1), Institute for Monetary and Economic Studies, Bank of Japan, 1999 (available at http://www.imes.boj.or.jp/cm/hmls/feature_gra2-1.htm). [2] Morio Seno'o, "Yamada Hagaki and the History of Paper Currency in Japan," IMES Discussion Paper No. 96-E-25, Institute for Monetary and Economic Studies, Bank of Japan, 1996 (the Japanese version is available at http://www.imes.boj.or.jp/cm/pdffiles/chosa552.pdf). [3] Bank of Japan, "Security Features of the New Bank of Japan Notes," 2004 (available at http://www.boj.or.jp/en/type/release/zuiji/kako03/bnnew3.htm). [4] Bank of Japan, Nagoya Branch, "Morizo Kiccoro no Osatsu World – Atarashii Osatsu no Hanashi Dagane (A Story of New Banknotes, Narrated by Morizo and Kiccoro, the Official Mascots of the 2005 World Exposition, Aichi, Japan)," 2004 (available only in Japanese at http://www3.boj.or.jp/nagoya/kaisatsu/world.pdf). [5] Bank of Japan, Payment and Settlement Systems Department, "Saikin no Denshi Money no Doko ni Tsuite (Recent Developments in Electronic Money)," 2008 (available only in Japanese at http://www.boj.or.jp/type/ronbun/ron/research07/data/ron0808b.pdf). [6] Bank of Japan, Payment and Settlement Systems Department, "Japan's Next-Generation RTGS," 2006 (available at http://www.boj.or.jp/en/type/ronbun/ron/research/data/ron0610a.pdf).
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Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at a meeting with business leaders, Nagoya, 2 September 2008.
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Masaaki Shirakawa: Recent economic and financial developments and the conduct of monetary policy Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at a meeting with business leaders, Nagoya, 2 September 2008. * * * Introduction I am honored to be here today to speak and to exchange views with business leaders from the Chubu region, and would like to take this opportunity to express my deep gratitude for your cooperation with the Bank of Japan's Nagoya Branch. Before we begin, I also would like to express my heartfelt sympathy to the people in the Tokai area who suffered damage from the unprecedentedly heavy rain observed last week. Today, I will speak about issues facing Japan's economy and the Bank's thinking regarding the conduct of monetary policy. I. The current situation of Japan's economy First, I would like to discuss the current situation of Japan's economy. Since the beginning of 2002, the economy has enjoyed a moderate but prolonged period of economic expansion. Since the end of last year, however, the pace of economic growth has gradually slowed. Business fixed investment has been leveling off because the rise in energy and materials prices, which has accelerated since this spring, has depressed corporate profits. Private consumption has also been relatively weak due to the ongoing price rise, while growth in wages has remained sluggish. The pace of increase in exports has slowed, because of the effects of a slowdown in overseas economies. Given this situation, the Bank's assessment at the Monetary Policy Meeting held on August 18 and 19 was that Japan's economic growth had been sluggish. Prices, on the other hand, have been on the rise. The year-on-year rate of increase in the domestic corporate goods price index (CGPI) exceeded 7 percent in July due mainly to the rises in prices of steel and petroleum products. This was the highest rate of increase in 27 years, since 1981. The year-on-year rate of increase in the consumer price index (CPI) excluding fresh food reached 2.4 percent in July. This was the highest rate in 16 years excluding fiscal 1997, when CPI inflation increased reflecting the rise in the rate of consumption tax. Japan currently faces a difficult situation given the sluggishness in the economy and the rise in prices. This situation has been caused by two factors: the disruptions in global financial markets and the slowdown in the global economy; and the surge in energy and materials prices. II. Disruptions in global financial markets and the slowdown in the global economy First, I will address a topic related to the disruptions in global financial markets and the slowdown in the global economy. Roughly one year has passed since the U.S. subprime mortgage problem emerged, underlying the disruptions in global financial markets, and the nature of this problem seems to have evolved over time. The first stage was the time of "liquidity constraints," when conduits and aggregators of securitized products and financial institutions faced difficulties in raising funds. Then the second stage emerged: the time of "credit contraction." In this stage, financial institutions have tightened their credit standards and their lending attitudes, and this has started to exert strong downward pressure on the economy. Most recently, a third stage has emerged. In this stage, delinquency rates of not only subprime-related products but also commercial real estate loans and consumer loans have been rising reflecting the sluggishness in the U.S. economy. As a result, a situation in which the sluggishness in the economy causes financial institutions' asset quality to deteriorate further – with further adverse impact on the economy – is becoming a focus of concern. To put it another way, at the third stage there are concerns about a negative feedback loop between financial markets, asset prices, and economic activity. U.S. economic growth is likely to remain sluggish for some time, since it is unforeseeable at present when and how the negative feedback loop will diminish. In Europe, economic growth is slowing further. In Asia, although the Chinese and Indian economies continue to post high growth, some of the NIEs and ASEAN economies are showing deceleration in exports and signs of slowing domestic demand. The growth rate in the world economy taken as a whole will inevitably slow, although it remains at a high level when compared with the average for the past three decades. III. The surge in energy and materials prices and Japan's economy Next, I will address a topic related to the surge in energy and materials prices. Since Japan depends heavily on imports of resources, a rise in such prices exerts downward pressure on Japan's economy through an outflow of income and exerts upward pressure on prices. The rise in crude oil prices during the current phase has been the largest, even compared with the two oil crises. During the first oil crisis, crude oil prices surged from 3 U.S. dollars to 12 dollars per barrel – a fourfold rise – and during the second oil crisis they surged from 15 dollars to 40 dollars – an increase of two and a half times. In the current phase, if we start from 2002, when the level of oil prices was 21 dollars, the present level of 110-120 dollars – somewhat below the recent peak – is more than five times the level recorded in 2002. As a result, the size of the income outflow resulting from the surge in oil prices has also been the largest during the current phase: about 5 percent of real GDP, compared with about 3 percent during the two oil crises. The effects of rises in crude oil prices, such as the resultant outflows of income and decreases in production capacity, cannot be offset unless export prices are raised to the same extent as import prices. Nevertheless, there seem to be many aspects where the situation can be improved through our own efforts. In fact, economic and price developments differed markedly between the periods immediately after the two oil crises emerged. During the first oil crisis, Japan's economy suffered from a combination of runaway inflation and economic stagnation – in other words, stagflation. The economy suddenly contracted, and CPI inflation peaked at an annual rate of 25 percent. Contrarily, during the second oil crisis, the economy continued to grow at a rate of 3-5 percent and the CPI posted only a single-digit increase. Of the various factors behind the difference in Japan's economic and price performance between the two oil crises, two seem to be most important. The first factor was the difference in the economic and price situation immediately before the crises as well as the policy response. Already prior to the first oil crisis, the economy was overheated and the financial environment was overly accommodative, having increased the inflation expectations of households and firms. Against this background crude oil prices surged, making matters even worse. On the other hand, when the second oil crisis occurred, the economy was not overheated, the financial environment was not overly accommodative, and monetary tightening was initiated in a timely manner. This kept inflation expectations low and thus succeeded in avoiding the second-round effects – a rise in prices of non-petroleum goods and services triggered by a rise in crude oil prices. The second factor was that Japan succeeded in transforming its economic structure while accepting the change in the relative-price structure due to the surge in crude oil prices. After the first oil crisis, Japanese firms pursued resource saving, and as a result, crude oil consumption per unit of output – the amount of crude oil used to produce a unit of value added – decreased in 1980 by 22 percent compared with the period of the first oil crisis. Meanwhile, Japanese firms made use of the change in the operating environment, seeking to develop energy-saving products. This experience clearly suggests policies necessary to cope with the current rise in crude oil prices. First, the second-round effects should be avoided so that inflation is contained within the rise in import costs and passing of the rise in import costs on to output prices. And second, it is crucial to promote a change in economic and industrial structures to make them compatible with the new structure of relative prices. It should, however, be noted that the current rise in crude oil prices has characteristics different from the past crises. In the past oil crises, supply constraints were the main cause of the rise in crude oil prices. In the current phase, on the other hand, the major cause was a change in the structure of the world economy resulting from the rapid rise of emerging economies. Looking at the current rise in crude oil prices from a somewhat longer-term perspective, we can also observe that it and the subprime mortgage problem share a similar background and thus have not occurred independently. IV. Issues facing the global economy and Japan's economy in the medium to long term Looking back on major trends in the global economy, we find that the rise in crude oil prices nearly coincides with the overheating in the markets for securitized products, including those backed by subprime loans. In the period that saw the onset of these two events, especially in and after 2003, the world economy enjoyed a positive combination of high growth and stable prices. A major factor supporting this combination was that the entry of emerging economies into the market economy expanded global supply capacity, providing an environment for low inflation. In this situation, accommodative monetary policy continued worldwide. In these favorable circumstances, however, problems that can be seen today in the world economy started to emerge. First, the rapid growth of emerging economies whose energy consumption was inefficient multiplied the demand for resources such as crude oil. In addition, in these economies, improvement in the level of income increased the demand for general merchandise such as food, and this raised inflation rates there. And second, as represented by the emergence of the U.S. subprime mortgage problem, investors and financial institutions eased their credit standards amid the prolonged, favorable economic environment and accommodative financial conditions, and this resulted in expansion of credit and a rise in asset prices. Although the causes of the subprime mortgage problem and the rise in crude oil prices are complex, they seem to share a similarity in that neither might have occurred without a continuation of high economic growth and accommodative financial conditions worldwide. This fact would seem to hold several implications for the future development of the economies of both Japan and the world. First, the world economy should be regarded as being in a process of transition to a sustainable growth path. An economic slowdown entails hardships in every economy. However, in view of the background of high energy and materials prices, which I mentioned earlier, a certain pace of adjustment in the world economy seems necessary for them to meet the conditions – such as stable resource prices – for moving to another stage of development. Second, from the viewpoint of the conduct of monetary policy in general, the risks that may arise from prolonged accommodative financial conditions warrant attention. Looking back at previous bubbles in financial activities and asset prices, including Japan's asset price bubble, we can see that many have occurred following a period of price stability and continued low interest rates. It is difficult, however, to recognize the emergence and bursting of a bubble as they happen. Given this, we should keep in mind the view that excessively accommodative financial conditions often cause large swings in the economy after a certain time lag, although such a view may not appear well grounded. And third, in view of the background of the current rise in energy and materials prices, the probability that these prices will fall back to the previous low levels is likely to be small, although the pace of increase seen to date may not continue. It therefore seems inappropriate to consider the current surge an "oil crisis," which implies a "temporary supply shock." In this situation, it is all the more important – even more so than during the periods of the two oil crises – for Japan's economy to transform firms' production structure into one that is compatible with the new structure of relative prices for better resource allocation, and to react positively to the change in the operating environment and create areas of high competitiveness. In this regard, Japanese firms have already started to undertake a range of projects, in response to the surge in energy and materials prices and growing interest in environmental issues. These include the reduction in use of structural steel and facilitation of the reuse of scrap, the use of alternative energy, and the introduction of energy-saving equipment. In these areas, large firms in particular have been increasing capital spending to improve efficiency. With regard to development of new products, automakers, for example, have been working to develop energy-saving products such as hybrid cars and electric cars, and sales of hybrid cars are growing steadily. Some electric manufacturers are increasing production of products related to alternative energy, such as solar batteries. V. The outlook for Japan's economy and the conduct of monetary policy In view of the issues I have discussed, I would now like to talk about the outlook for Japan's economy and the Bank's conduct of monetary policy. The Bank's main scenario is that growth will likely remain sluggish for the time being against the backdrop of high energy and materials prices and weaker growth in exports due to a slowdown in overseas economies. The sluggishness in Japan's economy has arisen against the background of the broad adjustments in the world economy that I mentioned earlier. In this situation, the point that should be examined is whether or not Japan's economy will experience a deep adjustment phase. I believe that the possibility of this occurring is small. Let me explain the thinking behind this projection. First, as a result of firms' restructuring efforts, which continued in the 1990s up until recently, the "three excesses" – namely, in production capacity, employment, and debt – have been eliminated, and Japan's economy has become more resilient to shocks that weaken economic growth. Second, losses incurred by Japanese financial institutions due to the subprime mortgage problem are limited compared to those of U.S. and European financial institutions and Japanese financial markets continue to be stable, which suggests that the functioning of the financial system remains intact. And third, Japan's financial conditions have been accommodative. Although it is a cause for concern that financing conditions of firms in construction and real estate industries and small firms in general are becoming increasingly severe, financial conditions taken as a whole have been accommodative. The short-term real interest rate calculated by subtracting the CPI inflation rate from the call rate has been negative, as the policy interest rate – the uncollateralized overnight call rate – has been at a low level of 0.5 percent. Firms' financing costs have also remained low. This accommodative environment for corporate finance is expected to continue to support business activity. Because of this, it is reasonable to expect, as the main scenario, that Japan's economy will return gradually to a moderate growth path as commodity prices level out and overseas economies move out of their deceleration phase. Let me now discuss developments in prices. Currently, the year-on-year rate of increase in the CPI exceeds the upper limit of the range of "understanding of medium- to long-term price stability" – that is, the level of inflation that each member of the Policy Board understands, when conducting monetary policy, as being consistent with price stability over the medium to long term. The assessment of price stability should, however, be based on whether it can be sustained in the medium to long term. From this point of view, the issue that requires particular attention is whether second-round effects will emerge. This largely depends on whether people's confidence in price stability is maintained, which ultimately is determined by the stance of monetary policy. We consider that the second-round effects are unlikely to emerge in the near term, given the current level of the domestic output gap, the inflation expectations of households, and firms' price-setting behavior. Developments in wages are one of the important indicators pointing to the emergence of second-round effects, and so far wage growth has been relatively weak. In sum, the rate of increase in consumer prices will likely remain elevated over the coming months, since the pass-through of earlier increases in import prices is expected to continue for a while. Thereafter, however, the rate of increase is expected to decline gradually in line with the expected moderation in the rises in international commodity prices and the resultant subsiding of firms' raising of sales prices. The outlook for economic activity and prices, however, entails considerable uncertainty, and various risk factors are influencing the outlook. Global financial markets, which I mentioned earlier, are likely to remain unstable for the time being, and there are downside risks to the world economy. Regarding the outlook for Japan's economy, there is a risk that domestic demand may weaken as a result of the outflow of income due to the high energy and materials prices. The Bank is therefore attentive to the downside risks to economic growth, although the economy does not face the need to adjust production capacity and employment. As for prices, the Bank is focusing on the upside risks to inflation. As I mentioned earlier, energy and materials prices have been rising for a long time and this rise should not be regarded as "temporary." Moreover, given that Japan's economy has not faced such a high level of inflation in recent years, the Bank should pay attention to the risk that possible changes in the inflation expectations of households and firms' price-setting behavior may generate second-round effects. As I have explained, the current situation requires the Bank to carefully monitor both downside risks to economic growth and upside risks to inflation. Furthermore, it should be mindful of the risk that if the downside risks to the economy turn out to decrease, prolonging the period of accommodative financial conditions may lead to swings in economic activity and prices, as the recent experience of the world economy suggests. The Bank continues to carefully assess the future outlook for economic activity and prices, closely considering the likelihood of its projections as well as factors posing upside or downside risks, and will implement its policies in a flexible manner. Moreover, since global financial markets are expected to remain unstable and there are various uncertainties in the outlook for economic activity and prices, it is essential for the Bank to ensure the stability of the Japanese financial markets. Closing remarks Thus far, I have spoken about the issues facing Japan's economy and the Bank's thinking regarding the conduct of monetary policy. It takes about one and a half to two years for the effects of monetary policy to permeate throughout the economy. It is therefore extremely important to make macroeconomic projections for the period covering this lag. You may be able to imagine the difficulty in making an accurate projection. However, speaking from my own experience as a policymaker, it is not easy even to grasp the current state of the economy. To succeed in doing so, a close analysis of both macroeconomic indicators and microeconomic information is essential. The indicators and information have both advantages and disadvantages. Macroeconomic indicators are important, but do not show the most recent developments due to the lag between the relevant period and the time of release. On the other hand, microeconomic information that is gathered through interviews with firms has an advantage of a minimal lag. The latter also includes information that cannot be expressed numerically, such as business sentiment. However, it also has drawbacks: there often is a significant disparity in the view of business conditions among firms and industries; and there may be also a tendency for respondents to play down positive news regarding their business. The Bank, keeping in mind both the advantages and limitations of the two types of information, strives to gather as much microeconomic information as possible using no small amount of operating resources. To explore the activities of various economic entities in depth, the Bank's 32 branches and 12 local offices throughout Japan perform an important role. Their analyses of regional economic developments and the behavior of firms and financial institutions in the respective region are concentrated in the Bank's Head Office through, for example, the meeting of general managers of the Bank's branches. The branches make reports based on the results of the Tankan (Short-Term Economic Survey of Enterprises in Japan) for the respective region, analyses of regional economic indicators, and interviews with firms and financial institutions in the region. The information gathered from the branches is summarized in the Bank's Regional Economic Report, which is released quarterly. The branches also disseminate information locally in their respective areas through the monthly release of a report on recent economic and financial developments and quarterly release of the Tankan for the respective region. The staff of the Bank's branches and offices, including the general managers, may have asked you on occasion to devote some time to completing interviews and Tankan surveys. I wish to express my deep thanks for your kind cooperation, and would like you to know that these interviews and surveys provide an essential foundation for the Bank's conduct of monetary policy. We seek your continued cooperation with us to this end, and please know that your opinions and requests are always welcome. Thank you very much for your kind attention.
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Speech by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at the Foreign Correspondents' Club of Japan, Tokyo, 29 September 2008.
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Kiyohiko G Nishimura: Recent economic and financial developments and the conduct of monetary policy Speech by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at the Foreign Correspondents' Club of Japan, Tokyo, 29 September 2008. * * * It is a great pleasure to be addressing this community of distinguished journalists at the Foreign Correspondents' Club of Japan. Today, I first wish to share with you how I see the current state of the Japanese economy and the outlook. And then I will touch on the implications of both for the future course of monetary policy. Diverse engines of growth and canceling-out of small shocks during economic recovery since 2002 To assess current economic activities in Japan, it is worthwhile to look back on the developments since 2002 as a starting point. 1 The Japanese economy has recovered continuously since hitting the bottom in early 2002. Although an average of around 2 percent real GDP growth during this period does not seem particularly high, it is above the economy's potential, and shows remarkable stability. Thestability comes not from a uniform decline of demand fluctuations across sectors, but from a canceling-out of small fluctuations of demand in different sectors. In fact, one salient characteristic of this period is that the timing of peak production varied among industries. In past business cycles, we commonly observed concurrent increases and decreases in production in various industries. A typical example is the so-called IT bubble and its collapse: production of not only IT-related goods but also other goods increased and decreased in tandem. In contrast, since 2002, various industries have taken the lead in production and have been successively replaced. For example, when the production of IT-related goods decreased, production in materials industries increased. I can point out two contributing factors, closely related to globalization. First, on the demand side, the engine of world growth has been diversified. High economic growth continued in countries such as China, India, Russia, and some in the Middle East, and Japan's exports to these countries increased considerably. As a result, the variety of goods exported, previously confined mainly to IT-related and durable consumer goods, broadened to include goods such as construction machinery and materials. Second, on the supply side, linkages between various industries in Japan became weaker as international diversification of production sites continued. When materials necessary to produce a particular good were imported rather than secured domestically, a decrease in domestic demand for this good did not have large direct negative effects on other domestic industries through the input-output relationship, although it reduced imports of materials. The diversification of demand and supply sources just described led to asynchronicity in production activity and resulted in canceling-out of small shocks in sectoral demand and supply, leading to a stable growth pattern. However, this also meant that we did not have a strong engine of growth affecting all sectors, and thus the speed of economic expansion was moderate. In fact, the recovery since 2002 has been led mostly by the corporate sector, For details of this assessment, see Kiyohiko G. Nishimura, "Increased Diversity and Deepened Uncertainty: Policy Challenges in a Zero-Inflation Economy," International Finance 10:3 (2007), 281-300, which is based on my speech at the Brookings Institution in July (http://www.boj.or.jp/en/type/press/koen07/ko0707a.htm). especially exporting firms. Corporate profits exceeded their previous peak and corporate fixed investment increased steadily. However, since growth was at best moderate, firms remained cautious in increasing their labor force and production capacity, and maintained their restrictive stance on wage increases. Although this cautiousness apparently has prevented firms from accumulating excess production capacity and excess labor so far, it has resulted in sluggish wage increases and ultimately, in a lackluster state of consumption. The current state of the Japanese economy In this way, the Japanese economy enjoyed not so strong, but stable and resilient, economic growth until the end of last year. Since then, however, the growth rate has slowed. First, there was the shock caused by a stringent revision of the Building Standard Law, resulting in a fall in housing and construction investment. Then came a sharp increase in energy and materials prices, which has caused a substantial transfer of income from Japan to oil and materials exporting countries. This decrease in real income had an adverse effect on both private consumption and corporate fixed investment. The decrease in corporate fixed investment has been noticeable especially among small and medium-sized enterprises that rely mostly on domestic demand and therefore do not benefit from strong increases in exports. Recently, exports have lost their momentum, reflecting the gradual slowdown of the world economy. The turmoil in the U.S. financial markets, which stemmed from the U.S. subprime mortgage problem, has affected economic activities in the U.S. as well as those worldwide. Currently, the Japanese economy is sluggish against the backdrop of high energy and materials prices and weaker growth in exports. Thus, it is particularly important to assess, first, developments in energy and materials prices and second, financial market conditions and their effects on economic activities, especially in the United States. Factors contributing to the surge in commodity prices Let me first examine the surge in commodity prices. There are three possible factors behind the recent surge. The first factor is the increase in demand especially in emerging economies, whose resource usage is not so efficient. The high growth rate of these economies has led to a rapidly increasing demand for energy and materials. The second factor is the difficulty of increasing the supply of these products in a timely manner. A large investment is required with a considerable lag between exploration and production. Moreover, projects are often impeded by environmental and geopolitical problems. The third is a financial factor. Global investors, confronted with the turmoil in global financial markets, are said to have shifted their investments from complex financial products to simple commodities. This so-called "flight to simplicity" may have contributed to the surge in commodity prices. Since the rise of commodity prices started well before the current financial turmoil, it is likely that it was the demand factor that set the long-run trend. However, it is hard to deny outright that supply constraints and especially financial factors contributed to recent acceleration until July. Although commodity prices have slipped back since around mid-July, they are likely to remain elevated if the demand-side factor in emerging economies does not change. The subprime mortgage problem and global financial turmoil I now turn to the subprime mortgage problem, and the resulting global financial turmoil, which is still under way. In financial markets, there are many investors with different preferences in terms of liquidity, return, and risk profile of financial products. Financial institutions effectively intermediate between these investors by providing various financial products. Securitization was an innovation that enabled financial institutions to provide a wider range of financial products with a view to meeting investors' various needs. In order to enhance confidence in newly introduced securitized products, various "supporting devices," such as liquidity-enhancement guarantees from banks, insurances by monolines, and credit ratings, were employed and used widely. Moreover, to facilitate transactions as well as to obtain profits, financial institutions themselves became active players in the securitized products market. Investors' confidence in financial products was first shaken in the spring of 2007 when prices of some tranches of subprime RMBS fell in a way unthinkable previously. This raised suspicion that information provided by rating agencies and utilized by financial institutions in their sales pitch was, after all, wrong. Erosion of confidence in the values of securitized products became increasingly evident as time went by. As confidence eroded, investors became extremely cautious and reduced transactions. 2 This led to a further price decline of securitized products and contributed to further erosion of confidence. Moreover, an old and more familiar vicious circle of financial stresses and economic slowdown was coming into play in recent months. The turmoil in global financial markets in the last several weeks has been extraordinary. Stock markets have been volatile and credit spreads spiked. Demand for liquidity has increased and there has been a conspicuous "flight to quality." In order to address the elevated pressures in U.S. dollar short-term funding markets, six central banks announced coordinated measures to supply dollar liquidity to money markets on September 18. The U.S. government announced a plan to buy impaired assets possessed by U.S. financial institutions. The purchase of impaired assets is particularly important in several ways. First, it will create liquidity and promote price discovery in the markets for these assets. Second, this measure will make the balance sheets of these financial institutions more transparent so a reasonable assessment of their financial condition can be made by investors, reducing uncertainty considerably. Although there remains considerable uncertainty about the outlook for global financial markets, I hope that a series of measures taken by governments and central banks will contribute to stabilization of the markets, leading to recovery in global economic growth. The outlook for economic activity and the risk factors I would now like to turn to the outlook for the Japanese economy. Our main scenario is that economic activity will likely remain sluggish for the time being against the backdrop of high energy and materials prices and weaker growth in exports due to a slowdown in overseas economies. The question is whether or not the Japanese economy will experience a deep adjustment phase. We believe that the possibility of this occurring is rather small. First, as a result of firms' restructuring efforts, which started in the 1990s and continued up until recently, the "three excesses" – namely, in production capacity, employment, and debt – have been largely eliminated. This suggests that the Japanese economy has become more resilient to shocks affecting economic growth. Second, the subprime-related losses of Japanese financial institutions are limited compared to those of U.S. and European counterparts. As a result, Japanese financial markets continue to function well, though there This seemingly overcautious behavior is not irrational. Rational investors, who are, say, 95% confident that these financial institutions' advice is true, but think that there is a 5 % chance that the institutions might be utterly incompetent and their advice might be wrong, always consider the worst outcome and try to improve it, rather than to maximize their profits taking the institutions' advice for granted. This decision situation is called ε-contamination of confidence. See Kiyohiko G. Nishimura and Hiroyuki Ozaki, "An Axiomatic Approach to Epsilon Contamination," Economic Theory, 27:2 (2006), 333-340. are occasional disturbances reflecting the stress in global financial markets. And third, Japanese financial conditions have been generally accommodative with a very low inter-bank call rate, although financing conditions in the construction and real estate industries, and small and medium-sized enterprises in general, are becoming increasingly tight. The shortterm real interest rate calculated by subtracting the CPI inflation rate from the call rate has been negative, as the policy interest rate – the uncollateralized overnight call rate – has been at a low level of 0.5 percent. This accommodative environment for corporate finance is expected to continue to support business activity. Thus, the main outlook scenario is that the Japanese economy will return gradually from its current sluggish condition onto a moderate growth path, as commodity prices stabilize and overseas economies move out of their deceleration phase. The outlook for economic activity, however, is accompanied by considerable uncertainty, and various risk factors could influence the outlook. Global financial markets, which I mentioned earlier, are likely to remain strained for some time, and there are downside risks to the world economy. There is also a risk that domestic demand may weaken further as a result of the outflow of income due to the elevated energy and materials prices prevailing until recently. The Bank is therefore attentive to the downside risks to economic growth, although the economy does not face urgent need to adjust production capacity and employment. As I have mentioned earlier, one salient characteristic of the economic recovery since 2002 was the diversification of growth engines and canceling-out of small shocks. In contrast, we are now facing two large shocks that may spread to many economies – the surge in energy and materials prices and the financial turmoil stemming from the subprime mortgage problem. We cannot totally rule out the possibility that, if these two shocks simultaneously impact heavily on the global economy, business conditions in various industries and firms in various regions might become synchronized, and thus trigger a negative feedback or amplification of adverse effects through interdependency. Thus, with respect to future developments in the real economy, we should be attentive to the downside risks. Low inflation in the recovery since 2002 and a spike in energy and material prices Let me turn to inflation. First I will explain why inflation was almost non-existent from 2002 up until the midyear of 2007. Then I will assess the current threat of a possible rekindling of inflation posed by the sharp increase in energy and material prices. As I have explained earlier, real GDP growth had been on average around 2 percent since 2002 until recently, somewhat above Japan's potential growth rate. The output gap, which was substantially negative before the economic recovery started, recovered gradually to its past average. However, the CPI inflation rate remained near zero until around the middle of last year. There are two factors contributing to this lack of response of prices to a change in output gap. First, competition has intensified against the backdrop of globalization and deregulation. Emerging economies, in the process of being incorporated in the global economy, have established themselves as global production sites with abundant and inexpensive labor. Imports from these emerging economies have increased dramatically and the competitive threat from these imports prevented domestic producers from increasing their product prices when demand recovered. Deregulation is another factor increasing competition, which is exemplified in the deregulation of large-scale retail stores. Competition has intensified among retailers, large or small, and they have tried to avoid charging higher prices even if demand picked up, fearing that they might lose their customers to their competitors. Second, wage increases have remained subdued throughout this period. Competitive pressures from emerging economies of inexpensive labor have become a major factor restricting increases in wages. Moreover, there are other factors specific to Japan. An increase in the number of non-regular employees with low wages is one. Another factor is the mass retirement of baby-boomers who were paid higher wages than young workers, and the resulting replacement of high-wage old workers by low-wage young ones. Furthermore, severe fiscal conditions forced central as well as local governments to restrain wages of government and related agencies' employees, which had a spill-over effect on other service industries. This subdued wage behavior might also be the product of the very low inflation expectations of private economic entities, reflecting the past low inflation record. The benign situation of low inflation has changed since the end of last year. The Corporate Goods Price Index has increased rapidly against the background of the surge in commodity prices to record annual increase of 7.2 percent in August. CPI inflation is also rising noticeably. Specifically, prices of petroleum products, such as gasoline and kerosene, and processed food have been increasing. Moreover, there are some spill-over effects on related service products, such as eating out and electricity. The rate of CPI inflation excluding fresh food increased from 0.5 percent in the fourth quarter of last year to 2.4 percent in August. However, if we exclude energy and food from the CPI, then the inflation rate has been still around zero, although it has crept up a little in recent months. Thus, the recent rise in the CPI inflation rate is mostly due to the rise in commodity prices and some pass-through to other goods and services. The outlook for prices and the risk factors The Bank first published its "understanding of medium- to long-term price stability" in 2006 and it has been reviewed annually. This document clarifies the level of inflation that each Policy Board member understands as being consistent with price stability over the medium to long term, in conducting monetary policy. The "understanding" is expressed in terms of the rate of change in the CPI, and currently falls approximately between 0 and 2 percent with most members' median figures at around 1 percent. The recent CPI inflation rate exceeds the upper limit of the range. However, the assessment of price stability should be based on its sustainability in the medium to long term. Thus, the real question is whether the current momentum of inflation is sustained in the medium to long run, or to put it another way, whether we see second-round effects of inflation. This depends on people's confidence in price stability, which ultimately is determined by the stance of monetary policy. At this moment, we are not seeing second-round effects, and it seems unlikely that they will emerge in the near term, given the current weakness of demand, households' negative reaction to price increases, and firms' price-setting behavior. Wagesetting is one important indicator of whether we have second-round effects, and so far wage growth has been relatively weak. Taking account of these recent developments, it is reasonable to expect that, although CPI inflation is likely to remain elevated over the coming months due to lagged pass-through of earlier increases in import prices, it will decline gradually in line with the expected moderation of worldwide commodity price inflation and tapering-off of import-price pass-through. However, we see risks in this main scenario, which are on the upside. As I mentioned earlier, increases in energy and materials prices are long-run phenomena, rather than temporary, reflecting the growing importance of emerging economies. Moreover, since this is the first outbreak of noticeable inflation in a decade, it may eventually change inflation expectations of households and firms' price-setting behavior. Taking these possibilities in mind, the Bank should pay close attention to the possible upside risk of a rekindling of inflation. The conduct of monetary policy Finally, I now turn to monetary policy. The Bank introduced the new monetary policy framework in March 2006 and has been explaining its monetary policy stance based on this framework. In this framework, the Bank first examines the prospects for economic activity and prices for one to two years ahead and assesses whether the economy will follow a path of sustained growth with price stability in the most likely scenario. This is policy assessment under the "first perspective." Then, the Bank assesses the risks considered most relevant to the conduct of monetary policy. This is policy assessment under the "second perspective." I would now like to outline the Bank's current assessment based on this framework which forms the basis for the conduct of monetary policy. In the "first perspective," the most likely outlook is that economic activity will remain sluggish for the time being, while the CPI inflation rate is expected to remain above 2.0 percent over the coming months. Thereafter, the economy is expected to return gradually onto a moderate growth path as commodity prices stabilize and overseas economies move out of their deceleration phase. CPI inflation is expected to moderate gradually as energy and materials prices level out and the pass-through of earlier increases in import prices is completed. Thus, after its current sluggishness, the economy is likely to return eventually onto a sustainable growth path with price stability. In the "second perspective," which assesses risks of the most likely outlook, we concluded that the Bank should monitor carefully both downside risks to economic growth and upside risks to inflation. Furthermore, if downside risks to the economy turn out to decrease, we should pay close attention to the risk of prolonging the period of accommodative financial conditions, which may lead to swings in economic activity and prices in the future, as the recent experience of the world economy suggests. In conducting monetary policy, the Bank will continue to carefully assess the future outlook for economic activity and prices, closely considering the likelihood of its projections as well as factors posing upside or downside risks, and will implement its policies in an accordingly flexible manner. Moreover, since global financial markets are expected to remain strained for some time and there are various uncertainties in the outlook for economic activity and prices, it is essential for the Bank to maintain market stability. The world's economies now face serious challenges. The Japanese economy is no exception. Uncertainties remain elevated both in financial markets, real economic activity, and inflation. To deal with these challenges, we believe it is important to explain carefully how we assess economic conditions and how we conduct monetary policy. To this end, we, the policy makers, must be good communicators. Providing necessary information appropriately will enhance the credibility of our policy-making. Also, as globalization proceeds, it has become increasingly important to communicate internationally. I think these thoughts can be shared with people like you who are professionals in the field of communication. In closing, before I leave you I would like to express our strong commitment to make appropriate economic assessments and policy decisions, and to explain them to the public appropriately in a timely manner. Thank you very much for your kind attention.
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Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Kisaragi-kai Meeting, Tokyo, 5 November 2008.
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Masaaki Shirakawa: The turmoil in global financial markets and economic and financial developments in Japan Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Kisaragi-kai Meeting, Tokyo, 5 November 2008. * * * Introduction I am very privileged to have the opportunity to speak before such a large audience. As you all know, global financial markets are currently experiencing a type of turmoil not seen since the 1930s. Strains in the markets have mounted significantly, especially since the bankruptcy filing of Lehman Brothers in September. It is difficult for a central bank to choose the right words to express this situation, but the blunt phrase "financial crisis" was used in the joint statement by major central banks released in October. The degree of strains in financial markets, although they have recently improved somewhat, has increased to a level that has obliged us to use such a strong phrase. The turmoil in financial markets that began in the summer of 2007 as well as its impact on economic activity were, at first, limited to the U.S. and European economies, but have since gradually spread to Japan as well as to emerging economies. This global turmoil has now become the largest problem facing the world economy, although the degree of impact varies by country. In my speech today, I would like to first discuss developments in global financial markets and overseas economies, given that current developments in Japan's economy are being overwhelmingly influenced by them. After that, I will discuss the outlook for Japan's economic activity and prices, and then the Bank of Japan's conduct of monetary policy, including the reduction in the policy interest rate decided at the Monetary Policy Meeting held on October 31. And lastly, I would like to touch on how a financial crisis should be dealt with and how, from a longer-term perspective, similar crises can be prevented in the future, based on our experience with the one that occurred in Japan. I. Developments in global financial markets and overseas economies I will begin by discussing developments in global financial markets and overseas economies. Looking back, until recently the world economy enjoyed a sustained period of benign economic conditions. The statement released after the meeting of the Group of Seven (G-7) finance ministers and central bank governors in April 2007, for example, indicated, "Although risks remain, the global economy is having its strongest sustained expansion in more than 30 years and is becoming more balanced." All of you here are familiar with developments in the world economy since then, but the understanding that high world economic growth had continued for a long time was, without any question, true until the recent past. In actual numbers, growth rates of around 5 percent continued from 2004 through 2007. Even with such high growth rates, inflation rates did not rise noticeably until around 2006. A major factor supporting this combination of low inflation and high economic growth was the entry of emerging economies into the market economy, which expanded global supply capacity, providing an environment for low inflation. In this situation, there was a prolonged period of low interest rates worldwide. In the beginning, the low interest rates seem to have been partly affected by arguments stressing the risk of deflation, and later by optimism that noninflationary sustained growth would continue, supported by the fact that benign economic conditions actually continued. In any event, the issues the world economy currently faces gradually accumulated in the benign environment of high growth, stable prices, and accommodative financial conditions. First, the rapid growth of emerging economies multiplied the demand for resources such as crude oil, and led to a surge in commodity and energy prices. And second, investors and financial institutions eased their credit standards and a global credit bubble emerged as evidenced by the U.S. subprime mortgage problem. Looking back on phenomena that occurred in this period, such as the substantial rise in asset prices, the surge in commodity and energy prices, and the significant increase in leverage by market participants, we now understand that they were generated by the overheating of financial and economic activities. The current global financial crisis and the slowdown in the world economy can therefore be viewed as part of the process of correcting imbalances that have accumulated. A. Developments in global financial markets and policy responses I will now discuss the problem of the current financial crisis. The problem surfaced when the economic entities that originated securitized products faced funding difficulties due to a decline in the prices of those products and malfunctioning of their market. Subsequently, the situation gradually deteriorated through the repetition of heightening and subsiding of pessimism in the market. Since the bankruptcy filing of Lehman Brothers in mid-September, strains in global financial markets, particularly those in the United States and Europe, have sharply intensified. Looking back at the financial crisis in Japan after 1997, the defining incident that triggered it was the default of Sanyo Securities in the money market. After that incident, a sense of vigilance for counterparty risk intensified in the market and screening of trading partners and contraction of the market started to set in. The recent conditions in global financial markets after the collapse of Lehman Brothers could be described as such a market contraction taking place on a global scale, leading to a heightened sense of counterparty risk particularly in the U.S. and European markets. Loss of trust is disastrous for markets. In the money market, where financial institutions exchange funds without collateral, the volume of trade dropped sharply, and trades offered were restricted to overnight funds, implying that there was a serious liquidity shortage. As a result, concerns among financial institutions and investors over funding became widespread in addition to concerns over a lack of capital, and this led to stricter lending and investing standards. This situation, if had no action been taken, would have deteriorated further. The world economy has accumulated various imbalances in the past several years, and adjustments to correct them are inevitable. Nevertheless, we must prevent further adjustments or turmoil that may be triggered by some shocks. Recognizing this, the participants at the October G-7 meeting shared a strong sense of crisis and confirmed that each member country would promptly implement necessary policy measures with determination, in order to ensure the stability of global financial markets and confidence in the financial systems. The results of the discussions were published as a set of concise and clear principles, the G-7 Plan of Action. Many countries have been implementing decisive measures including responses in line with the Plan of Action, and these measures can be summarized as follows. The first was to carry out aggressive provision of liquidity to ensure financial market stability. Central banks have been providing massive liquidity to the markets, and, with respect to U.S. dollar liquidity, central banks including the Bank of Japan have cooperated internationally to introduce a framework of liquidity provision and have been providing a large amount of dollars in the market of each country. However, while central bank liquidity provision is an indispensable measure for preventing a systemic risk from manifesting itself and for ensuring financial market stability, it is not a silver bullet to fundamentally resolve the financial system problem. We should be fully aware that liquidity provision by a central bank is a measure to gain time until more fundamental solutions have been worked out. The second measure taken was a comprehensive guarantee of financial institutions' debts. During financial system instability, the concern of depositors and investors tends to intensify exponentially once it passes a tipping point. Leaving such a situation unresolved could amplify their concern and thus lead to uncontrollable turmoil. Therefore, governments in the United States, Europe, and other countries, in quick succession, announced that they would expand deposit insurance coverage substantially and guarantee financial institutions' debts. The third measure was to put in place a framework that used public funds to purchase impaired assets held by financial institutions and inject capital into financial institutions. Given that the financial system problem is essentially a problem of a capital shortage, it is necessary to identify the amount of capital shortage and compensate for it. However, as Japan's past experience suggests, it is extremely difficult to accurately gauge, on a real-time basis, the size of impaired assets and a capital shortage when a negative interaction is at work in the financial and economic systems. To ensure financial stability, someone must make a judgment on the capital shortage from a macroeconomic perspective, and that someone can only be the public authorities. The public authorities must decide on a substantial public funds injection if it is judged necessary after thoroughly factoring in future downside risks. While it appears that the condition of global financial markets has somewhat improved as a result of a series of measures being taken by the public authorities, strains in the financial markets are highly likely to continue for the time being. B. Developments in overseas economies Given the situation in global financial markets, economic activity in the United States has been sluggish with continued adjustments in the housing market. The losses incurred by financial institutions were at first mainly on securitized products related to the subprime mortgage problem, but recently losses on consumer and commercial real estate loans have been on the rise. Despite the reduction of the Federal Reserve's target for the federal funds rate from 5.25 percent to 1.0 percent within the short period of a little over a year, the actual interest rates applied to funding by financial institutions, firms, and households are generally rising due to wider credit spreads. The tightening in financial conditions is exerting downward pressures on the economy, and this is leading in turn to deterioration in the asset quality of financial institutions. In other words, a negative interaction is operating between the financial system and economic activity, and the outcome of events is still not clear. In Europe, financial institutions' lending attitudes have become tighter as in the United States. Demand in the area is slowing due to the deterioration in the terms of trade reflecting the earlier increases in commodity and materials prices, and export conditions are worsening reflecting developments in the world economy. In this situation, economic activity in Europe has also been sluggish. Emerging economies and commodity-exporting countries continue to show high growth, albeit at a somewhat slower pace. However, in the NIEs and the ASEAN economies, domestic demand has been showing weakness, and the pace of increase in exports is slowing due to the deceleration of the U.S. and European economies. II. Developments in Japan's economy A. The current situation of and outlook for Japan's economy 1. The current situation of Japan's economy Let me now move on to the current situation of and outlook for Japan's economy. From the beginning of 2002 until recently, Japan's economy enjoyed a moderate but prolonged period of economic expansion. It was the longest postwar expansion, and with hindsight, this was the result of the high and prolonged growth of the world economy that I mentioned earlier as well as restructuring efforts of Japanese firms. Since the end of 2007, however, the pace of growth has slowed, and has become increasingly sluggish recently with the deterioration in the world economy. There are two main reasons behind these developments. The first reason is the sharp deterioration in the terms of trade, reflecting the surge in energy and materials prices toward the summer of 2008. The deterioration in the terms of trade is more pronounced in Japan than in other major economies, since Japan depends heavily on imports of commodities and most of its exports consist of manufactured products. The significant deterioration in the terms of trade has weakened corporate profits and household real income and exerted downward pressure on domestic private demand. The second reason is the slowdown in overseas economies. Japan's exports in real terms showed high growth until this spring, but later decelerated and have leveled off recently. Growth in exports to the United States has been sluggish since the end of 2006, but that of exports to Europe and Asia has also recently started to slow. As for prices, the year-on-year rate of increase in the consumer price index (CPI) for all items excluding fresh food has risen to around 2.5 percent against the background of the continued pass-through of the rise in energy and materials prices. This is the highest rate in 16 years excluding fiscal 1997, when the increases in the CPI reflected the rise in the rate of consumption tax. The Bank's current assessment, however, is that, second-round effects – price inflation that exceeds the level of increase caused by the pass-through of the rise in energy and materials prices – have not emerged. 2. The outlook for economic activity and prices The outlook for Japan's economic activity is the largest concern at the moment. The Bank released the October 2008 Outlook for Economic Activity and Prices (Outlook Report) on October 31, which contains projections through fiscal 2010. Given that monetary policy takes effect with a considerable time lag, it is necessary that a central bank make long-term projections of future economic activity and prices. The Bank has extended the projection period for the October Outlook Reports, and the recent report presented projections through fiscal 2010. Currently, the uncertainties regarding the world economy and the global financial markets have increased significantly, making future projections of economic activity and prices more difficult than usual. Accordingly, it is necessary to stress that a careful assessment of not only the baseline scenario but also risk factors is even more important than usual. Bearing that in mind, I would like to explain the baseline scenario. It is expected that increased sluggishness in economic activity in Japan will remain over the next several quarters and that it will take some time for the necessary conditions for Japan's economic recovery to be satisfied. It is likely to be sometime after the middle of fiscal 2009 that the economy will return gradually onto a moderate growth path and that the growth rate will pick up toward its potential – estimated to be around 1.5 percent or somewhat higher. The rate of real GDP growth on a fiscal-year basis is likely to be around 0 percent in fiscal 2008 and around 0.5 percent in fiscal 2009, and the growth rate for fiscal 2010 is expected to be around the potential growth rate. The future of Japan's economy relies heavily on the recovery of overseas economies and also on the stability of global financial markets, which will form the basis for the recovery of the world economy. Growth in overseas economies is likely to continue to slow in coming quarters. Key factors for the future course of the world economy will be how and when the adjustments in the housing market progress and measures introduced to stabilize the financial system start to take effect in the United States. It is likely that improvements in the U.S. economy as well as the recovery in the growth rate of overseas economies as a whole will become evident only sometime after the middle of fiscal 2009. With regard to future developments in prices, the rate of increase in the CPI for all items excluding fresh food is expected to decline gradually until the middle of fiscal 2009, as energy and materials prices stabilize, while aggregate supply and demand conditions are expected to loosen, with real GDP growth falling short of the potential growth rate. On a fiscal year-on-year basis, the CPI (excluding fresh food) is projected to rise by around 1.5 percent in fiscal 2008 and remain more or less flat in fiscal 2009. Thereafter, it is projected to increase somewhat and register an increase in the range of 0.0-0.5 percent in fiscal 2010, as commodity prices are likely to rise gradually reflecting the recovery in overseas economies and the aggregate supply and demand balance in the economy is likely to improve moderately. What is important in the conduct of monetary policy when faced with a decline in the inflation rate is developments in medium- to long-term inflation expectations. In this regard, medium-term inflation expectations have barely changed during the recent period of price rises, and it is not anticipated in the current projections that they will change during the coming period of price decline. B. Uncertainty regarding the outlook for Japan's economic activity and prices In sum, the most likely outlook is that increased sluggishness in Japan's economic activity will remain over the next several quarters, but in the longer run, the economy will return onto a sustainable growth path with price stability. However, this outlook is attended by a significant level of uncertainty. The first and the largest risk factor is the outcome of financial crises in the United States and Europe. If the negative interaction operating between financial markets and economic activity in the United States and Europe should worsen, this may lead to a further slowing in these economies and may further delay their recovery. If growth of the world economy slows as a whole due to a subsequent slowdown in emerging economies, not only will Japan's exports decline but also the slowdown in the world economy may reduce business fixed investment by altering firms' expectations of an increase in global demand. The second risk factor concerns developments in energy and materials prices. It is assumed that, in the medium term, these prices will rise moderately, supported by growing demand especially in emerging economies. However, this assumption is, again, accompanied by uncertainty. If the current fall in these prices, which implies an improvement in Japan's terms of trade, mainly reflects the slowing of the world economy, it should be borne in mind that this also implies a decrease in Japan's exports. On the other hand, if commodity prices should surge again, inflationary pressures may increase globally, which could raise the specter of a subsequent economic slowdown. In the latter case, it is possible that the factors behind the recent sluggishness in Japan will become more acute. The third risk factor concerns a possibility that, if strains in global financial markets and financial crises in the United States and Europe should result in significant fallout in Japanese financial markets and financial institutions, financial conditions will become less accommodative and pressures acting to depress economic activity may become more marked. Turning to the outlook for inflation, there are also uncertainties attending inflation that could cause it to deviate either upward or downward from the rate projected. With regard to the Bank's projection that the inflation rate will likely decline, however, the upside risks to this projection seem to have decreased relative to the past. C. Conduct of monetary policy I would now like to explain the Bank's thinking regarding the conduct of monetary policy based on the outlook for Japan's economic activity and prices I have described. Japan's economy, in the longer run, is most likely to return onto a path of sustainable growth with price stability; however, the outlook is attended not only by increased downside risks to economic activity but also by decreased upside risks to inflation relative to the recent past. Given the above assessment and outlook for the economy, the Bank decided on the following measures at the Monetary Policy Meeting held on October 31. First, the Bank decided to lower the policy rate or the target for the uncollateralized overnight call rate by 20 basis points, from around 0.5 percent to around 0.3 percent. And second, the Bank further increased the flexibility of money market operations to ensure stability in money markets in order to facilitate the provision of sufficient liquidity toward the year-end and the fiscal year-end, when market liquidity usually becomes tight. More precisely, a facility called the Complementary Deposit Facility was introduced as a temporary measure to pay interest on current account balances, and the interest rate was set at 0.1 percent. Under this facility, the Bank will pay interest on current account balances – excess reserve balances, to be exact – that financial institutions hold with the Bank, and the interest rate applied will form the floor of market interest rates, since financial institutions will not have any incentive to offer funds in the call market below this rate. The new facility will enable the Bank to smoothly provide sufficient liquidity without causing large fluctuations in the call rates. Extensive discussions have taken place regarding the amount of reduction in the policy interest rate and the level of the interest rate to be applied to current account balances. Before explaining the discussions, the basic mechanism whereby monetary policy takes effect through financial markets needs to be recalled. As I said earlier in relation to the case of U.S. and European money markets since the bankruptcy filing of Lehman Brothers, financial institutions cannot take risks when there are concerns over funding in the market. In this situation, monetary easing measures will not produce sufficient effects even with the low level of short-term interest rates. In this sense, ensuring the functioning of money markets – in other words, ensuring the flow of funds among market participants – is an important precondition for monetary policy to produce its intended results. In Japan, where the policy interest rate had already been reduced to the extremely low level of 0.5 percent, further reducing the policy interest rate will lower the interest income to a level insufficient to cover various transaction fees, which in turn may reduce the volume of transactions in the market and bring about a reduction in market liquidity. To put it differently, the Bank must consider carefully not only the positive effects of monetary easing, but also the possible adverse effects that might hamper the proper functioning of the market mechanism and impede the flow of funds. In the current situation where the influence of the turmoil in global financial markets is gradually being felt in Japanese financial markets and considerable deterioration in the functioning of the market mechanism can be observed, liquidity shortage in markets is becoming an increasingly serious problem. Also with regard to the spread between the targeted interest rate and the floor interest rate, an excessively narrow spread will hamper free interest rate formation and impair the functioning of the markets. The reason behind the Bank's decisions, after extensive discussion, to set the policy interest rate at around 0.3 percent and the spread at 20 basis points was to strike a balance between the monetary easing effects of the reduction in the policy interest rate and its negative effects on the functioning of the market in the current difficult situation facing Japan's economy and financial markets. The Bank has taken various decisive measures, besides those that I just mentioned, to ensure stability in financial markets. The most important among them was the introduction of U.S. dollar funds-supplying operations in September as a coordinated measure of central banks in major economies. With the global decline in the liquidity of dollar funding markets, the dollar funds-supplying operations seem to be making a contribution to supporting economic activity by easing concerns among Japanese financial institutions as well as nonfinancial firms over dollar funding. Furthermore, on October 14, the Bank decided to increase the frequency and the size of CP repo operations and to broaden the range of eligible collateral. Moreover, at the Monetary Policy Meeting held on October 31, the Bank lowered the basic loan rate applicable under the Complementary Lending Facility. Through this facility, the Bank extends loans to financial institutions in the amount they need within the value of collateral submitted. The basic loan rate, the interest rate applied under the facility, is the ceiling of overnight market rates. The reduction in the basic loan rate will further limit the rise in overnight call rates and help to ensure market stability. If I were asked to provide the Bank's basic stance with regard to future monetary policy, I would have to repeat that given the increased uncertainty, the Bank will implement monetary policy appropriately by carefully assessing the future outlook for economic activity and prices, closely considering the likelihood of its projections as well as factors posing upside or downside risks. At the current juncture, particularly close attention should be paid to the risk of downward deviation in economic activity due to developments in the U.S. and European financial systems and global financial markets as well as their subsequent impact on economic activity. The current shock that is threatening the world economy and Japan's economy can be regarded as part of the process of correcting the unsustainable growth in the world economy and expansion in leverage that continued over the past several years. With strains in financial markets continuing under the severe adjustment process, the most important contribution a central bank can make is to ensure stability in financial markets through its provision of liquidity. Market stability is also a vital precondition for the current low interest rates to produce their maximal monetary easing effects. Keeping in close contact with overseas central banks, the Bank will do its utmost to ensure market stability by conducting appropriate money market operations. III. Lessons learned from the financial crisis As the last topic of my speech, I would like to offer my views on how we can avoid financial crises, based on the experience of addressing Japan's financial system instability following the bursting of the bubble economy. A. Policy responses to the current financial crisis In response to the current financial crisis, governments and central banks worldwide have announced decisive measures in rapid succession in order to ensure the stability of global financial markets and confidence in the financial system, and have been implementing these measures while seeking international coordination. The most important of these measures are liquidity provision by central banks and injection of public funds into financial institutions by governments. Not all the problems would be solved immediately even if public capital were injected into financial institutions on an appropriate scale, however. That is because this would not immediately correct the imbalances and excesses generated in each sector of the economy as we found in Japan; a comprehensive framework for reinforcing financial institutions' capital by using public funds was established in 1998 in Japan, but it was only after 2003 that the economy started to return to a full-fledged recovery path, with the resolution of the "three excesses" of production capacity, employment, and debt in the corporate sector, and the support of recovery in overseas economies. Looking at the present condition of the U.S. economy, the sector that comes to mind first as having an "excess" is the housing market. Housing prices are still declining and it seems that it will take some time for the adjustment in the housing market to be completed. While it is difficult to specify the amount of excess in the household sector's debts, the past trend seems to suggest the existence of a certain amount of excess. Not only had the financial sector grown substantially, but also the overall financial activity in the economy had greatly increased. More globally, as symbolized by the recent case of Iceland, the financial sector had been growing in recent years but is now shrinking. Various adjustments to reduce the excesses are likely to continue for the time being, and during this period downward pressures will continue to weigh on economic activity. To enable such adjustments to proceed as smoothly as possible, it is important for the authorities to take necessary measures with determination, as steps toward ensuring stability in the financial markets and confidence in the financial systems. Fortunately, the measures for achieving the stability and confidence seem to have been put generally into place. B. Preemptive policy measures Next, I would like to consider what policy measures are necessary to prevent the emergence and worsening of a financial crisis. The correct set of answers has yet to be found, but I would like to offer some tentative suggestions. 1. Proper conduct of macroeconomic policy The first is to pursue proper macroeconomic policy. There have been a range of discussions on the causes of the subprime mortgage problem, and there is a view that it is a new type of financial crisis. I believe that, although there were complex new securitized products and changes in the mechanism of crisis generation, what happened was the generation, expansion, and bursting of a traditional bubble, a phenomenon that has occurred repeatedly in the past. That is to say, in a favorable macroeconomic environment, asset prices increased markedly and leverage expanded substantially. Japan's experience during the latter half of the 1980s and the first half of the 1990s, and the current U.S. subprime mortgage problem – or, more broadly, the turmoil in the U.S. and European financial markets – have in common the fact that the essence of the problem is the generation and bursting of a bubble. How monetary policy relates to the bubble is extremely complex, and nobody can provide a clear answer at present, but it might not be a mere coincidence that Japan's bubble and many subsequent bubbles were generated when prices were stable or the rate of inflation was declining, a situation in which low interest rates were sustained. And in the current U.S. subprime mortgage problem, investors and financial institutions relaxed their risk assessment standards and leaned increasingly toward pursuing short-term profits by expanding their investments in securitized products, which included subprime loans as underlying assets, while increasing leverage. In the United States, the ratio of the outstanding balance of residential mortgages to nominal GDP rapidly increased from 49 percent in 2000 to 75 percent in 2006. An increase in leverage was not brought about by monetary policy only, and there had to be some convincing story that made the public's sentiment bullish. At the same time, the increase in leverage did not occur without an expectation that low interest rates would continue against a backdrop of prolonged global growth and low inflation, and associated credit expansion. Given such experiences, the proper conduct of monetary policy is extremely important. While price stability is the objective of a central bank's monetary policy and thus is extremely important, if price stability is understood to mean always containing the growth rate of the CPI within a certain narrow range, it could, as various recent experiences show, lead to large economic fluctuations, and eventually result in the loss of price stability itself. 2. A macroprudential perspective The second point crucial for preventing the emergence and worsening of a financial crisis is the importance of maintaining a macroprudential perspective. Let me take the example of residential mortgage-backed securities (RMBSs), securitized products that have residential mortgages as underlying assets, which were the trigger of the current global financial crisis. Investment in RMBSs, in which borrowers of residential mortgages that consist of underlying assets are distributed widely across regions and professional classes, enables investors to diversify risk unique to where they live, for example, the level of natural disaster risk or bad debt risk. However, if a housing bubble common to every region and professional class is generated, the economic value of the RMBSs will rapidly decline together with the bursting of the bubble. In this context, to ensure financial system stability, financial institutions for their part are required to manage risks properly, while the supervisory authorities and central banks need to have a macroeconomic perspective to cover not only individual risks that financial institutions incur, but also risks inherent in the financial system. The authorities and central banks use the term "macroprudential" to describe such a perspective, and it is important in checking whether proper risk management is in place through regulations, supervisions, and monitoring of individual financial institutions, as well as in conducting a risk analysis of the financial system as a whole and in disseminating information as necessary. Macroeconomic and market information converge at the Bank, as the monetary policy authority. At the same time, since the Bank is in a position to obtain information from individual financial institutions through its on-site examinations and off-site monitoring, it is strongly aware of the significance of having a macroprudential perspective. While it is not an easy task to establish a specific macroprudential methodology, the Bank has been recently making efforts to do so and publishing part of the fruits of these efforts in its Financial System Report. The Bank would like to continue to strengthen and exercise its macroprudential function. 3. Improvement in market and settlement infrastructure The third point important for preventing the emergence and worsening of a financial crisis is to steadily improve market and settlement infrastructures, and contain systemic disruptions if a financial crisis occurs. While the current global financial markets are in a state of strain, the turmoil would have been worse without the efforts that have been made in recent years by market participants and central banks to improve market and settlement infrastructures. One example is the Continuous Linked Settlement (CLS) Bank established in 2002, with the cooperation of major central banks and private financial institutions, to reduce foreign exchange settlement risk. Under the previous settlement system, anyone selling the yen would be exposed to the settlement risk associated with the time difference between paying the yen in Japan time and receiving U.S. dollars in New York time. Now, since the CLS system links the fund settlement system of individual countries and carries out multiple currency settlements associated with foreign exchange transactions simultaneously, the settlement risk unique to foreign exchange transactions has been reduced. As vigilance for counterparty risk is intensifying since the Lehman shock, this system has been functioning very effectively to ensure smooth foreign exchange transactions and settlements. Since financial institutions in individual countries are increasingly relying on foreign exchange swap markets, which convert the home currency into foreign currency, to procure foreign currencies, it is highly significant that the smooth functioning of the foreign exchange market has been maintained. In addition, there have been various developments both domestically and internationally to improve various forms of financial infrastructure through the concerned parties' steady efforts, and these are ongoing. From the viewpoint of enhancing financial markets' efficiency and strengthening resiliency against a crisis, the Bank will continue to actively support concerned parties' efforts to improve market and settlement infrastructures. Closing remarks At present, the world economy and Japan's economy are facing quite a severe situation. In my closing remarks, based on my experience with financial crises, I would like to share with you my convictions on three aspects of the role of a central bank. First, I am convinced that the conduct of monetary policy is becoming ever more important. The recent experiences in various countries seem to suggest that it has become increasingly important to view monetary policy as a tool to achieve stable financial and economic environments that can be sustained over time, rather than a tool for fine-tuning to achieve macroeconomic stability. Second, I am convinced of the importance of the aspect of a central bank as "the bank for banks," that is, its banking function. To cope with the current financial crisis, the central banks around the globe, including the Bank, have been implementing various operations to provide financial markets with ample liquidity, and have been striving to maintain financial stability. Provision of U.S. dollar funds is one typical example. Policy with respect to central bank collateral is also important. When market functioning has declined, particularly important are the types of assets a central bank accepts as collateral, and their prices. While the media tend to focus on monetary policy in the sense of interest rate policy, the current experience has strengthened my conviction that the function of a central bank as a bank is just as important. Third, I am convinced of the importance of on-site examinations and off-site monitoring. As shown by the Federal Reserve Bank of New York's lending to Bear Stearns, and years ago by the Bank of Japan's provision of emergency liquidity assistance to Yamaichi Securities, whether a central bank extends lending to financial institutions as a lender of last resort for banks is critically important for financial system stability. Given that a central bank has such a role, collecting information through on-site examinations and off-site monitoring is indispensable in accurately gauging the liquidity and soundness of individual financial institutions. It is also important for a central bank to utilize such information in devising liquidity provision and in making a macro risk assessment. At present, there is ongoing deliberation in international forums such as the Financial Stability Forum concerning the system design of a global financial market and a financial system including the procyclicality of regulations – the effect whereby frameworks of regulations and supervisions for financial institutions amplify economic fluctuation through financial institutions' behaviors. More and more people are arguing that the presence of financial activity in the economy became too large. If such criticism becomes too strong, leading to a rejection of the proper roles played by financial activity, it would do great damage to the economy in the form of a decline in growth over time. Therefore, as a central bank, we will actively contribute to the discussion of specific system designs. Thank you very much for your attention.
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bank of japan
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Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at a special meeting hosted by the Kyushu Association of Corporate Executives, Fukuoka, 1 December 2008.
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Masaaki Shirakawa: Recent financial and economic developments and the conduct of monetary policy Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at a special meeting hosted by the Kyushu Association of Corporate Executives, Fukuoka, 1 December 2008. * * * Introduction I am honored to be invited to speak at the special meeting hosted by the Kyushu Association of Corporate Executives. I have a close relationship with the Kyushu region because I lived in Kokura, my home town, until I graduated from high school, and also worked as the General Manager at the Oita Branch of the Bank of Japan for one and a half years, from 1994 through 1995. Currently, 7 of the 32 branches are in the Kyushu region. I would like to express my deep gratitude for your cooperation with these branches. Today happens to be the 67th anniversary of the establishment of the Fukuoka Branch, and I am doubly delighted to have the opportunity to speak today before business leaders in the region on such a memorable day. At present, the world economy, including Japan's economy, faces a very difficult situation as the effects of the financial turmoil stemming from market developments in the United States and Europe have been spreading worldwide. I would first like to talk about the current situation of both of the domestic economy and overseas economies, and also the ongoing global financial crisis, and then explain the Bank's thinking regarding the conduct of monetary policy. I. The current situation of and outlook for Japan's economy Today I will speak about developments in Japan's economy mainly from a macroeconomic perspective. Anticipating that some of you may be concerned that the Bank does not fully understand the circumstances specific to each region and each firm, I will stress that the Bank is fully aware of different circumstances by region, industry, and firm size that cannot be perceived only from a macroeconomic perspective. Such differences are reported regularly by General Managers of the Bank's branches. In addition, I have had far more opportunities to discuss with business leaders in various regions since being appointed as the Governor of the Bank of Japan, and on these occasions I have been reminded of the differences. In today's speech, I will focus on the major trends in the world economy and Japan's economy, but I would like to stress again that, when assessing economic developments, the Bank always takes into account microeconomic information such as economic developments in each region and business performance of firms. Let me first discuss the current situation of Japan's economy. Looking back, since the beginning of 2002 Japan's economy has enjoyed a moderate but prolonged economic expansion. Since the middle of 2007, however, the economy has experienced a series of negative shocks, and now faces a difficult situation. The first shock came from a sharp decline in housing investment since the middle of 2007, due to the coming into force of the revised Building Standard Law. Growth in corporate profits and wages has been subdued, due to the deterioration in the terms of trade reflecting increases in energy and materials prices, and as a result growth in business fixed investment and private consumption has been slowing since around the end of 2007. The slowdown in overseas economies has become pronounced as strains in global financial markets and in the U.S. and European financial systems have intensified since this summer, and reflecting this, growth in Japan's exports turned negative. Given these developments, economic activity in Japan has become increasingly sluggish recently. Economic data, including the index of industrial production, released at the end of last week showed severe economic circumstances. The pace of the recent increase in the sluggishness of Japan's economy has been rapid, and overseas economies are also undergoing a similar drastic change. The U.S. economy has deteriorated reflecting the emergence of a negative feedback loop operating between financial and economic activities as the financial crisis stemming from the subprime mortgage problem increased in severity. European economies are also deteriorating, with increased downward pressure on economic activity from the financial side. Moreover, the effects of the weakness in the U.S. and European economies have been spreading to Asian economies. China has continued to show relatively high growth, but the country's growth in exports has recently slowed somewhat and investment related to real estate has been relatively weak against the backdrop of a fall in real estate prices. In the NIEs and the ASEAN economies, domestic demand has been weak while export growth has been decelerating, and these economies have been slowing. A slowdown in the world economy taken as a whole has become evident as the effects of the financial crises in the United States and Europe spread steadily to Asian economies. According to the World Economic Outlook released at the beginning of last month by the International Monetary Fund (IMF), output of advanced economies is expected to contract for the first time in the post-war period; growth in emerging economies is also expected to decline from the past several years' high growth of around 8 percent to 5-6 percent; and the growth of world output is projected to fall substantially to 2.2 percent. This is significantly lower than the world growth of around 5 percent registered for four years in the mid-2000s. The timing of the recovery in overseas economies depends on several prerequisites for recovery, and with regard to the U.S. economy the key questions are how adjustments in the housing market will progress and when the financial system will regain stability. I must admit that the timing of the recovery in the growth rate of overseas economies as a whole is highly uncertain, but given the current severe situation it seems appropriate to assume that the growth rate of overseas economies taken as a whole is likely to show a clear recovery only after the middle of 2009. As overseas economies are expected to continue to face a difficult situation, Japan's economy, which recorded negative growth in the second and the third quarter of this year, is likely to continue to show increased sluggishness over the next several quarters. The primary reason why the Bank takes this view is that the effects of developments in overseas economies and of the turmoil in global financial markets, which I mentioned earlier, have been steadily spreading to Japan's economy. I will elaborate on this later. The price situation has also changed significantly. Looking back to about a year ago, the year-on-year rate of change in the consumer price index (CPI) for all items excluding fresh food was around 0 percent, but then rose at a rapid pace, especially in petroleum products and food, due to the pass-through of higher commodity prices, and reached 2.4 percent this summer. However, most recently it began to decline due to the drop in commodity prices. Given recent developments in commodity prices, it is projected to fall at a rapid pace going forward. The major factor behind the drastic change in the trend of the CPI is changes in import costs. In addition, changes in aggregate supply and demand conditions and in the expected inflation rate also affect prices. Aggregate supply and demand conditions will likely ease, as growth in real GDP is expected to continue to fall short of the potential growth rate for the next several quarters. Although it depends on developments in prices of petroleum products and materials, the rate of change in the CPI may, for a brief period, turn negative in fiscal 2009. Bearing in mind these developments in Japan's economy, I will now move on to the factor that I regard as most important when discussing future developments in Japan's economy and overseas economies – the impact of the ongoing financial crises in the United States and Europe on overseas economies and on Japanese financial conditions. II. The financial crises in the United States and Europe and their impact As you all know, the current financial crises stemmed from the emergence of the U.S. subprime mortgage problem. Since then, the severity of the situation has intensified with pessimisms rising and falling in a repetitive pattern. In particular, the situation changed drastically just after the bankruptcy filing of Lehman Brothers, which led to a continuation of the intensified strains in global financial markets. Looking back, the problem surfaced as "liquidity constraints" when conduits and aggregators of securitized products and financial institutions faced difficulties in raising funds, which were triggered by declines in prices of securitized products backed by subprime mortgages. The next stage was a development of the "credit crunch"; losses incurred by financial institutions that possessed a large amount of securitized products expanded, and their capital bases were impaired. As a result, financial institutions tightened their credit standards and their lending attitudes, and this started to exert strong downward pressure on the economy. And now we face the current situation, where the negative feedback loop operating between financial and economic activities has intensified. Delinquency rates of not only mortgage loans but commercial real estate loan and consumer loans have risen reflecting the weaker U.S. economy. Consequently, capital bases of financial institutions have been further impaired, and their lending attitudes have become even tighter. In addition, firms' fund-raising conditions in the markets have deteriorated, as seen in the difficulty faced by firms in issuing CP and corporate bonds and the extreme rise in issuance rates. They have ultimately had an adverse impact on economic activity – the emergence of a negative feedback loop operating between financial and economic activities. Meanwhile, the Federal Reserve has lowered its target for the federal funds rate from 5.25 percent to 1.0 percent since last September. In spite of this monetary easing, the issuance rates of corporate bonds have risen compared with the level observed in the summer of 2007. In addition, we can point out the worldwide propagation as one of the features of the current financial crises. There were some failures of major financial institutions in the United States following the bankruptcy filing of Lehman Brothers, and failures started to be seen also in Europe. Furthermore, the financial crises in the United States and Europe are starting to affect emerging economies, and the inflow of funds to these economies has decreased substantially. There are various transmission channels. For example, in recent years emerging economies in Central and Eastern Europe experienced active credit expansion by foreign financial institutions based in Western Europe but now see a decline in loans outstanding. Moreover, some emerging economies became incapable of raising funds from global financial markets and finally needed financial assistance from the IMF. Thus, unlike the past currency and financial crises in Latin America and East Asia, the ongoing financial crises in the United States and Europe propagated rapidly around the globe. The progress in the globalization of financial and economic activities since the 1990s has strengthened the financial and economic interaction between countries. And the current economic deceleration or deterioration in each country is the first global economic slowdown to take place in a period of such drastic changes in the environment. In addition, the economic growth rate has deteriorated with unusual speed. With these characteristics of worldwide propagation and unusually rapid deterioration, pessimistic views tend to propagate easily and themselves promote further deterioration in the economy. Under these circumstances, it is necessary to understand the nature of the ongoing problem in order to consider policies necessary to address the situation. Let me first explain the swift and successive policy responses of governments and central banks. First is the provision of liquidity by central banks. Central banks have been making efforts to stabilize money markets by implementing U.S. dollar funds-supplying operations under a coordinated framework in addition to providing sufficient liquidity in their own currency. Second is placing troubled financial institutions under government control and injecting public funds. Third is the substantial expansion of the coverage of deposit insurance and the guaranteeing of financial institutions' debts. As a result of these measures, the situation in money markets in the United States and Europe has improved compared with the situation at the height of the tensions in those markets. However, the conditions in the money markets are far from normal, as seen in the fact that the 3-month dollar funding rate in the interbank market is around 2 percent higher than the yield on government bonds with the same maturity. Global financial markets remain under significant stress as seen in continued high credit spreads such as those on corporate bonds. Stock prices have plunged worldwide, and foreign exchange rates have continued to fluctuate widely. Why haven't conditions improved in spite of the swift actions taken by each country? As one of the reasons, we can point out that, given the various large excesses and imbalances accumulated in the several years up to the current global economic deceleration and deterioration, and financial crises, the process of adjustments will inevitably be deep. As I mentioned earlier, a prolonged period of worldwide high growth never witnessed before continued for several years in the mid-2000s. In addition, inflation rates declined due to an expansion of production capacity resulting from the participation of emerging economies in the global market economy, and low interest rates continued in the environment of high growth and low inflation. In the process, various excessive activities, both economic and financial, were undertaken and "excesses" were accumulated. Behind the rise of the U.S. subprime mortgage problem and the surge in crude oil and materials prices observed until this summer, there were global high growth and expansion in financial leverage. Of course, there were some voices warning about the situation. However, given that the economy was in a favorable condition, it was difficult to accept such warnings as is often the case given the nature of human beings and society. The world economy is now undergoing a process of adjustment of various excesses that had been accumulated, to achieve more sustainable growth. Under these circumstances, it is necessary to implement appropriate macroeconomic policies while maintaining financial system stability by injecting public funds into financial institutions in order to prevent the economy from falling into a deep adjustment phase or turmoil. Although such policies have been implemented, losses incurred by financial institutions and their capital shortages tend to expand when a negative feedback loop between financial and economic activities is operating. Hence, uncertainty remains as to the final amount of losses that need to be covered and of public funds injection required. The large losses that arise from adjusting accumulated excesses can only be covered by flows of income generated by daily economic activities, and this will inevitably take time. III. Financial conditions in Japan Let me explain financial conditions in Japan as an extension to what I have said about the global financial system. Financial markets in Japan, which had remained stable relative to these in the United States and Europe, have also drastically changed since the bankruptcy filing of Lehman Brothers. Measured by the spreads between interbank funding rates and government bond yields, the situation in the Japanese money markets remains comparatively favorable to date, but it seems that careful analysis of the possibility that pressures acting to depress economic activity from the financial side may increase in Japan is becoming necessary. In the conduct of monetary policy, it is extremely important but nonetheless difficult to judge how accommodative or how tight financial conditions are in a country. To make an accurate judgment of financial conditions, the Bank examines them from various angles, which may include evaluation of the level of interest rates and asset prices, quantitative monetary analysis making use of monetary aggregates and bank loans, interviews with financial institutions and non-financial firms, and various surveys. From the perspective of corporate financing, the Bank, in a manner similar to corporate management, examines the situation based on two criteria: first, at what interest rates funds can be raised; and second, how easily these funds can be raised, in other words, the availability of funds. Let me discuss the current financial conditions facing firms from those two perspectives. First, with respect to funding rates, interest rates on bank loans remain at a low level. On the other hand, interest rates applied to funding in the market, such as issuing CP and corporate bonds, are rising reflecting growing risk aversion among investors such as investment trust companies and life insurance companies, under the influence of the turmoil in global financial markets. The issuing rates on corporate bonds have been rising especially for those with low credit ratings, and issuing rates on CP, which had been creeping up since the summer, have risen rapidly since September. Although the level of these interest rates is somewhat lower than in 1998 and 1999 when corporate financing experienced a period of increased pressures, the so-called credit crunch, the pace at which these rates are rising is comparable to that in 1998 and 1999. In addition, when evaluating the level of funding rates, comparing them with corporate profitability becomes important. In Japan, the ratio of funding in the market to bank borrowings is approximately one to four, giving bank borrowings the dominant share. Because of this, even with the current sharp rise in issuing rates on CP, funding rates as a whole remain broadly unchanged and remain very low relative to firms' profitability. On the other hand, in 1998 and 1999, funding rates were nearly at the same level as profitability due to the sharp decline in the latter. From these points, it is clear that the current level of funding rates itself is still accommodative. Nevertheless, corporate profits are under strong pressure due to the effects of earlier increases in energy and materials prices and the increased sluggishness in economic activity, which have led to a decline in profitability. This seems to indicate that the level of funding rates relative to profitability is becoming less accommodative. Second, with respect to the quantitative side, the availability of funds is showing marked changes. With regard to funding in the market, the rate of increase in the amount outstanding of CP issued, which had been around 10 percent year on year since 2007 until the failure of Lehman Brothers, declined sharply thereafter owing to growing risk aversion among investors, and has recently fallen below the previous year's level. Furthermore, the postponement of corporate bonds issuance, which had been limited to firms with low credit ratings, is spreading to firms with high credit ratings, which in the past had been able to issue bonds without difficulty. Under these circumstances, it seems that firms' attitudes are becoming increasingly defensive against the backdrop of the deceleration in global economic growth and the turmoil in financial markets as well as increased future uncertainty, and this is leading to a growing number of firms hoarding liquidity. Meanwhile, the rate of increase in the amount outstanding of bank loans is rising on the whole, particularly loans to large firms. However, the number of firms reporting tight lending attitudes of banks have been increasing, particularly among firms in the construction and real estate industries and small firms. To sum up, financial conditions in Japan seem to have become less accommodative at an accelerating pace, particularly in terms of availability of funds, reflecting the turmoil in global financial markets. Although future conditions for funding depend on various factors, among them the level of bank capital and conditions in global financial markets are important. Currently, the capital ratios of banks, in general, are considerably above the level required by regulation. However, banks, when actually making loans, consider not only their capital ratios at the time but also various other factors such as expected future credit costs. Recently, given the declines in stock prices, the market risk of stock holdings is having an impact on bank capital, in addition to increased credit costs incurred by banks due to the increase in bankruptcies. Although at present the rate of increase in the amount outstanding of bank loans is rising, banks' lending attitudes will tend to become more cautious if they are not confident about the level of their capital bases. Furthermore, if the turmoil in global financial markets should intensify, there is a risk that funding in the market might become more difficult as a result of increased risk aversion among investors. Although the decrease in issuance of CP and corporate bonds, as a whole, is covered by the increase in bank loans as shown in the data up to the most recent figure for October, the Bank will monitor future developments carefully. IV. The conduct of monetary policy So far I have explained the present situation of and the outlook for the world economy and Japan's economy. With regard to Japan's economy, the increased sluggishness in economic activity is likely to persist for the next several quarters and, going forward, attention needs to be paid to the downside risks to economic activity arising from developments in the financial crises in the United States and Europe and their influence as well as financial conditions in Japan. Turning to prices, upside risks have decreased compared with the past, and there is a possibility that the inflation rate will decline further if downside risks to economic activity materialize or commodity prices fall further. Based on these assessments, the Bank, at the Monetary Policy Meeting held on October 31, reduced the policy interest rate by 20 basis points to 0.3 percent. With regard to the conduct of monetary policy, the Bank, given the increased uncertainty, will carefully assess the future outlook for economic activity and prices, closely considering the likelihood of its projections as well as factors posing upside or downside risks, and will implement monetary policy appropriately. For the time being, it is particularly important to pay attention to the downside risks to economic activity that may arise from developments in the U.S. and European financial systems and in global financial markets as well as their influence. To produce maximal monetary easing effects, it is a necessary precondition that markets function in a stable and smooth manner. When this condition is not met, as the recent situation in the United States shows, the actual funding rates may rise notwithstanding the substantial reduction in policy interest rates. From this standpoint, the Bank has undertaken various measures. The first aim of these measures is to ensure stability in money markets through provision of liquidity. The Bank has not only been providing sufficient funds in yen, but also been providing dollar funds, based on the internationally coordinated framework, with no limitation on the amount as long as they are within the value of collateral submitted. The second aim is to facilitate corporate financing. As I mentioned earlier, financial conditions are currently becoming less accommodative mainly in terms of funds availability, and the risk that the effects of the current low interest rates may not permeate through the economy is increasing. The Bank has already been conducting purchases of CP under repurchase agreements, and to facilitate corporate financing, the Bank has started to increase such purchases since October, and further increased them since November. Furthermore, the Bank is currently working on practical ways to contribute as a central bank to facilitate corporate financing during the run-up to the calendar and fiscal year-ends. The Bank will decide what measures to employ and put into action as soon as this work is completed. Various efforts by parties concerned are essential to address the current severe economic conditions, and the Bank will continue to do its utmost to facilitate the return of Japan's economy to a sustainable growth path with price stability. Although what actual policies are desirable depends ultimately on the situation in terms of economic activity, prices, and financial conditions at the time, the Bank will take appropriate measures in light of its purpose stated in the Bank of Japan Act, that is, to ensure stability in prices and the financial system. Closing remarks In closing, I would like to touch upon economic developments in the Kyushu region and discuss Asian economies that have close relations with this region. There have been dynamic changes in the structure of the economy in the Kyushu region, making the most of its geographical advantage of being the closest to Asian economies. Japan's exports to Asian economies, for example, have increased around twofold during the last 10 years, whereas exports from the Kyushu region increased around threefold. Growth in exports of Japan's major products, such as electrical machinery and automobiles, is substantially higher in the Kyushu region relative to Japan as a whole. As a result, the share of secondary industries, such as those producing electrical machinery and automobiles, in the Kyushu region is increasing – the region is sometimes referred to as "Car Island" or "Silicon Island" – and the region is becoming a hub for Asian trade. The Kyushu region is now making the most of being the closest to Asia, which has the fastest growing economies in the world. Assessing the growth potential of Asian economies, therefore, is important, but there are differing views on this and, ever since the 1990s, there have been various arguments. For example, the World Bank, in a book titled "The Asian Miracle: Economic Growth and Public Policy" published in 1993, stated that Asian economies had entered an autonomous growth cycle induced by direct investment. On the other hand, Paul Krugman, this year's Nobel laureate, stated in a 1994 article titled "The Myth of Asia's Miracle" that Asian growth was merely driven by extraordinary growth in inputs of resources like labor and capital, and Asian "tigers" were more like "paper tigers" because their growth was not accompanied by gains in productivity. More recently, there has been discussion as to whether the so-called "decoupling," whereby emerging economies will continue their high growth despite the slowdown in advanced economies, or "coupling," where emerging economies will be influenced by the slowdown in advanced economies, applies to the current state of the world economy. Recent developments indicate that Asian economies are decelerating due to the deterioration in the U.S. and European economies, as I mentioned earlier, and so any "decoupling" or "coupling" is clearly not perfect. In Asia, various countries and regions, one after another, have accomplished economic take-off starting with the NIEs, followed by the ASEAN economies and China, and then by India. And Asia taken as a whole has attained high growth through countries and areas at different stages of development influencing on each other. Developments in Asian economies have a strong bearing on the future of the economy in the Kyushu region together with developments in Japan's economy and in the world economy as a whole. In discussing the future of Asian economies, although it may well depend on how long the economic weakening in the United States and Europe continues, the Bank will pay close attention to whether strong intraregional demand in Asia can be maintained through making the most of economic dynamism in Asian economies with the assistance of economic policy actions in countries such as China. As I mentioned in the beginning, the Bank collects information on the regional economies through research conducted at its branches. As I have already said, I worked in the Oita branch of the Bank for a year and a half during the early 1990s, and one of the advantages that I enjoyed as General Manager was being able to hear candid views from the management of various firms in the region regardless of firm size. I had an experience of visiting a small convenience store at the time and hearing views on the business of convenience stores from a couple managing the store in their family room upstairs. The name, the Bank of Japan, may give you the impression that we are making policy judgments only from macroeconomic data or information collected in the metropolis, but this is not so. Since the interest rate policy affects areas throughout the country, we make efforts to collect a wide array of information to make our judgment. To this end, I would like to ask for your continued support. I am looking forward to hearing your views on the current situation of and issues facing the Kyushu economy as well as your requests to the Bank. Thank you very much for your kind attention.
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Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, to the Board of Councillors of Nippon Keidanren (Japan Business Federation), Tokyo, 22 December 2008.
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Masaaki Shirakawa: Global financial crisis and policy responses by the Bank of Japan Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, to the Board of Councillors of Nippon Keidanren (Japan Business Federation), Tokyo, 22 December 2008. * * * Introduction I am honored to have this opportunity to speak before business leaders in Japan here today. Time flies, and it is only about a week before the turn of the year. Looking back, this year has been a particularly severe one both for overseas economies and Japan's economy. The slowdown in the world economy gradually became pronounced, reflecting the turmoil in global financial markets since the summer of 2007, and the situation changed significantly especially since the bankruptcy filing of Lehman Brothers in mid-September. Many in corporate management have expressed the view that the sharp downturn in overseas economies and Japan's economy over the past several months is one they have never experienced before, and the severity of the situation is clearly shown in the recent economic data. Today, I would like to take this opportunity to review this year's developments in global financial markets, the world economy, and Japan's economy, talk about the background to the current global financial crisis, and lastly explain the Bank of Japan's thinking on the conduct of monetary policy. I. Global financial markets and the world economy I would like to start with developments in global financial markets and the world economy. As you know, the turmoil in global financial markets since the summer of 2007 was caused by declines in the prices of securitized products backed by subprime mortgages. It is not appropriate to limit our understanding of this trouble as "the subprime mortgage problem" or interpret it as "the financial sector's fault". In essence, it was caused by the bursting of a global credit bubble – a phenomenon generated by a combination of the rise in asset prices and the increase in credit and leverage. During the period of the credit bubble, firms in general enjoyed the fruits of high growth in the world economy. The rise and bursting of the credit bubble was observed to the greatest degree in the U.S. economy, but other economies also experienced similar phenomena, albeit with some differences in degree. The turmoil in financial markets surfaced as "liquidity constraints" when conduits and aggregators of securitized products and financial institutions faced difficulties in raising funds. Losses incurred by financial institutions eventually expanded due to declines in the prices of various securitized products, and this in turn led to a tightening of credit standards. As a result, there was downward pressure on economic activity, impairing financial institutions' assets. As was the case in Japan after the bursting of the bubble, financial conditions in the United States deteriorated with market participants' pessimism rising and falling in a repetitive pattern. Needless to say, the situation deteriorated sharply since the bankruptcy filing of Lehman Brothers in mid-September. Since then, market participants and investors have been extremely sensitive to counterparty risk and have significantly increased their risk aversion. Consequently, the volume of transactions in financial markets dropped sharply and market liquidity declined not only in uncollateralized funds transactions, but also in collateralized ones such as repo transactions, which are fund transactions with collateralized bonds, and foreign exchange swaps. The situation deteriorated further, with a widening of credit spreads on corporate bonds and a further decline in the prices of securitized products. This is evidenced by the fact that the price level of securitized products such as collateralized loan obligations (CLOs), which are products backed by corporate loans, has dropped to around 20 percent of the level observed before the summer of 2007 in the case of single A-rated products. In the United States, delinquency rates have risen not only for mortgage loans but for commercial real estate loans and consumer loans as well, reflecting the weaker U.S. economy. Reflecting this, the capital bases of financial institutions have been further impaired, and their lending attitudes have become even tighter – the emergence of a negative feedback loop between financial and economic activities. To address the situation, which can be described as a "financial crisis," governments and central banks have already taken decisive measures. Central banks have strived to stabilize financial markets by aggressively providing liquidity in their own currencies. In addition, since September major central banks including the Bank of Japan have been providing a massive amount of liquidity in U.S. dollars in their respective markets under a coordinated framework. Since the bankruptcy filing of Lehman Brothers, governments have undertaken such measures as placing troubled financial institutions under government control and injecting public funds, substantially expanding deposit insurance coverage, and providing guarantees for financial institutions' debts. Despite the numerous measures taken in each country, global financial markets as a whole remain under great strains. In money markets, interest rates on comparatively short-term instruments have recovered to the level before the bankruptcy filing of Lehman Brothers, due partly to the decisive measures taken by governments and central banks to date. However, interest rates on longer-term instruments remain elevated. Stock prices have fluctuated widely against the backdrop of concerns over the outlook for the world economy. Credit spreads on corporate bonds have been at a high level due to concerns about corporate performance. The tightness of liquidity conditions among financial institutions has begun to improve somewhat, but the crux of the problem has now shifted to the magnitude and duration of adjustments in the world economy. The slowdown in the world economy has gradually become marked in 2008. In particular, the negative feedback loop operating between financial and economic activities is no longer confined to the U.S. and European economies but has recently begun to be observed in other economies, indicating that the conditions of the world economy have become more severe. At the beginning of December, the National Bureau of Economic Research (NBER), which determines the business cycle of the U.S. economy, announced that the U.S. economy, which had been expanding from November 2001, already entered a recession phase in December 2007. The Federal Reserve has significantly reduced its target for the federal funds rate since last fall. Nevertheless, due to the widening of credit spreads, the interest rates applied to loans extended to financial institutions, firms, and households have been rising so far. With regard to the housing market, which holds the key to the outlook for the U.S. economy, adjustments are likely to continue. Given the tightening lending attitudes of financial institutions, it is likely that fund-raising conditions will remain severe for firms and households. The prevalent view regarding the timing of the recovery in the U.S. economy seems to be the latter half of 2009, but I think that this view is backed by the expectation that the current severe situation is likely to continue for some time, and not by some reasoning indicating that the economy is likely to recover from that time. In any event, it is likely that the current recession may become the longest in the postwar era, longer than the 16 months recorded in the periods 1973 to 1975 and 1981 to 1982. Economic conditions in Europe have also deteriorated. As in the U.S. economy, the lending attitudes of financial institutions have tightened, and pressures acting to depress economic activity from the financial side have intensified. In addition, the slowdown in emerging economies – for example, in Asia, Central and Eastern Europe, and Latin America – where economic conditions have been favorable until relatively recently, has become increasingly pronounced due not only to the decrease in their exports reflecting the deterioration in economic conditions in the United States and Europe but also to the adverse effects on domestic demand in emerging economies from the turmoil in global financial markets. Economic growth rates around the globe have been declining simultaneously and rapidly, albeit with some differences in level, as the effects of the financial crises in the United States and Europe have spread to other economies. Without a doubt, the distinctive features of the current recession are "simultaneity" and "rapidity." At present, not only advanced economies such as the United States, Europe, and Japan but also emerging economies are undergoing either an economic slowdown or a recession simultaneously for the first time since the formerly planned economies joined the world of the market economies. As for the rapidity, it is obvious from the degree of downward revisions made to GDP growth rate forecasts since the beginning of this year. According to the World Economic Outlook released by the International Monetary Funds (IMF), the growth of world output for 2009 was projected to be 4.4 percent in January, but was revised downward to 2.2 percent in November. The output of advanced economies was also revised downward from 2.1 percent to minus 0.3 percent. Why has the world economy simultaneously faced rapid economic deceleration? There are a few likely hypotheses. First, the nature of economic downturn may have changed due to the globalization of financial markets. It is no exaggeration to say that a negative feedback loop, which I have just discussed with regard to the U.S. and European economies, is now operating on a global basis. A typical example of this can be seen in the reduction of credit extension to emerging economies by U.S. and European financial institutions. Second, technical innovations in the field of information and communications, as represented by supply chain management, may have had an impact. While supply chain management has enabled efficient management of production and inventories, at the same time it may have also facilitated rapid recognition of the decline in final demand, inducing sharp reductions in production. Additionally, with today's easy access to diverse information via the Internet, changes in the psychology of corporate management and consumers may have become increasingly synchronized around the globe. Third, with the global economic deceleration and turmoil in financial markets never experienced before, feelings of anxiety and defensive behavior may have spread globally, further accelerating the downturn. I am not sure which of these hypotheses on the simultaneity and rapidity of the economic deceleration actually applies. Regardless, the background to the deceleration in world growth boils down to the single fact that various "excesses" accumulated during the prolonged period of high growth that continued until recently. Looking back, the world economy, until recently, had been enjoying unprecedentedly favorable conditions. High growth rates of around 5 percent continued from 2004 to 2007. On the other hand, prices, notwithstanding high growth, remained stable on the whole until the recent past, due to an expansion of production capacity resulting from the participation of emerging economies in the global market economy. Although memory fades, there were hot discussions in 2004 on the risk of deflation. "China exporting deflation" and "threat of deflation" were issues often addressed at international conferences. Low interest rates continued for a prolonged period in an environment of high growth and low inflation. In this continued benign environment of high growth, stable prices, and low interest rates, various excessive activities, both economic and financial, were undertaken and "excesses" accumulated. Investors and financial institutions eased their credit standards, and a global credit bubble emerged. The substantial rise in asset prices, the surge in commodity and energy prices, and the significant increase in leverage by market participants were all indications of excessive financial and economic activities. Looking calmly at the current deterioration in economic conditions around the globe, it can be viewed basically as part of the process of correcting the "excesses" that accumulated during the period of the credit bubble. As you know, Japan experienced this adjustment process from the 1990s to the beginning of the 2000s, following the bursting of the economic bubble. Japan's economy finally started to return to a full-fledged recovery path with the resolution of the "three excesses" of production capacity, employment, and debt. In the case of the U.S. economy, key factors for the economy to recover will be how adjustments in the household sector progress and to what extent financial institutions can write off their losses and enhance their capital bases. Future developments in the world economy will be critical as well. Looking back, Japan's economic recovery materialized with the support of high growth in overseas economies. However, the current situation is difficult in that this time the outlook for the world economy is highly uncertain. II. Current situation and outlook for Japan's economy Next, I would like to discuss the current situation of Japan's economy and the outlook for its future, taking into account the developments in global financial markets and the world economy that I have just described. Japan's economy continued to enjoy a moderate but prolonged economic expansion from the beginning of 2002, but since the middle of 2007 the economy has been hit by a series of negative shocks, and become increasingly sluggish. Economic growth began to slow from around the end of 2007, due mainly to a sharp decline in housing investment as the revised Building Standard Law came into force. Growth in corporate profits and wages has been subdued due to the deterioration in the terms of trade since this spring reflecting increases in energy and materials prices, and as a result growth in business fixed investment and private consumption has been slowing at a moderate pace. The slowdown in overseas economies has become pronounced as strains in global financial markets and in the U.S. and European financial systems have intensified since this summer, and reflecting this, growth in Japan's exports turned negative. And since September, tightening in corporate financing, which I will discuss later, has started to negatively influence economic activity. With these negative effects accumulating, economic conditions have recently been deteriorating. The results of the December Tankan (Short-Term Economic Survey of Enterprises in Japan) released last week also indicated the severe situation of Japan's economy. Looking ahead, we judge that economic conditions are likely to increase in severity for the immediate future. This is because domestic private demand is likely to weaken further as corporate profits decline, firms' funding conditions deteriorate, and the employment and income conditions in the household sector worsen, and also because exports are expected to decrease sharply due to the further slowdown in overseas economies and the appreciation of the yen. As for prices, the year-on-year rate of change in the consumer price index (CPI) for all items excluding fresh food had been around 0 percent from around 2003, but from around the end of 2007 it rose at a rapid pace, especially in petroleum products and food, due to the surge in commodity prices, and reached 2.4 percent this summer. Thereafter, it began to decline reflecting the drop in commodity prices. Looking ahead, given that aggregate supply and demand conditions will likely ease as growth in real GDP is expected to fall short of the potential growth rate for the next several quarters, and that commodity prices have been falling, the rate of change is expected to moderate further. In sum, economic conditions have been deteriorating and are likely to become still more severe in the immediate future. With regard to risk factors, much depends on the future developments in the financial crises in the United States and Europe and their impact, and on developments in overseas economies and financial conditions in Japan. Attention must be paid to the further downside risks posed to economic activity. As for prices, there is a possibility that the inflation rate will decline further if the downside risks to economic activity materialize or commodity prices fall further. Among the risk factors affecting the outlook for Japan's economy, I have already discussed the situation of the world economy. Financial conditions in Japan have deteriorated sharply on the whole. This can be seen in tighter funding conditions in the CP and corporate bond markets as well as in an increasing number of small and even large firms which report that their financial positions are weak and the lending attitudes of financial institutions are severe. Should the severity in financial conditions such as the lending attitudes of financial institutions and in the issuance of CP and corporate bonds increase, pressures acting to depress economic activity from the financial side may intensify. With regard to bank loans, which had been covering the decline in the issuance of CP and corporate bonds, the December Tankan shows an increasing number of firms reporting that the lending attitudes of financial institutions have tightened. The increase in the number of corporate bankruptcies and the fall in stock prices observed recently may, through a rise in credit costs and an increase in the risk associated with stockholdings, change financial institutions' risk-taking behavior, thereby leading to a tightening of their lending attitudes. In this regard, the current situation in Japan requires careful examination of a possible negative feedback loop operating between financial and economic activities. III. Conduct of monetary policy Having discussed the current situation and the outlook for Japan's economy, I will now turn to the Bank's conduct of monetary policy. Since September, when the turmoil in global financial markets and in the U.S. and European financial systems increased in severity, the Bank has promptly undertaken various measures. These can be categorized in three areas: reductions in policy interest rates, measures to stabilize the market, and measures to support corporate financing. I would now like to explain the thinking behind these policy measures, including those decided last week. First are the measures taken as interest rate policy. Since February last year, the Bank had maintained the target of its policy interest rate, the uncollateralized overnight call rate, at 0.5 percent. At the end of this October, the Bank reduced the target to 0.3 percent, and it was further reduced to 0.1 percent last week. The Federal Reserve, last week, also reduced its target for the federal funds rate, and set the interest rates on required and excess reserve balances at 0.25 percent. At the same time, the Federal Reserve announced that the exceptionally low level of the federal funds rate will continue for some time. When interbank overnight interest rates are lowered this far, meaningful policy in terms of stimulating demand through interest rates shifts toward easing firms' accessibility of funds. This holds true in both Japan and the United States. In this sense, measures that will ensure stability in financial markets and maintain an environment to extract maximal monetary easing effects are extremely important. In this area, the Bank implemented U.S. dollar funds-supplying operations soon after the bankruptcy filing of Lehman Brothers as a coordinated measure among the central banks in major economies, and has been supplying sufficient dollar funds ever since. These operations are currently being conducted without limitation on the amount, as long as it is within the value of collateral. As a result, dollar funding rates have declined, mainly for shorter terms, and these operations are supporting economic activity by relieving the funding concerns of Japanese firms through reducing the dollar funding pressures among financial institutions. With regard to yen funds, the complementary deposit facility has been introduced to enable smooth and sufficient provision of funds, and funds for over the year-end have been provided in larger amounts than a year before. Although the influence of intensified tensions in the global financial markets is being felt in Japanese markets in the form of large fluctuations in stock prices and a widening of credit spreads in the corporate bond market, Japanese financial markets have still been relatively stable compared to U.S. and European markets, in part because of the swift money market actions taken by the Bank. In addition, at the Monetary Policy Meeting held last week, the amount of outright purchases of JGBs was increased from 14.4 trillion yen per year to 16.8 trillion yen per year. This is to supply longerterm funds and resolve the problem of having to conduct frequent short-term funds supplying operations, thereby facilitating smooth money market operations. Along with money market stabilizing measures, the Bank has introduced various measures to support corporate financing with a view to extracting maximal monetary easing effects. In advanced economies, the parties that extend credit directly to firms are private financial institutions and investors, and the role of central banks is to indirectly support this credit extension. Specifically, the role of central banks is to provide liquidity through money market operations and to take corporate debt as eligible collateral for its credit extension to private financial institutions. If central banks implement measures that take on the credit risks of individual firms, this will inevitably take away the businesses of private financial institutions. In addition, considering the increasing possibility of incurring losses, undertaking such credit risks must be examined from various aspects such as role sharing with the government in a broad sense, the financial health of the central bank, and confidence in the currency. In this connection, when the Federal Reserve introduced its outright purchases of CP, it attached various safety measures such as accepting only the most highly rated CP. As I mentioned earlier, financial conditions in Japan are deteriorating sharply on the whole, and the risk that low interest rates may not exert their intended impact on economic activity has increased. Based on this recognition, since this September the Bank has introduced various measures to reduce such risk through providing liquidity to financial institutions and expanding the range of eligible corporate debt accepted as collateral. The Bank has already been conducting purchases of CP under repurchase agreements, and these have been significantly increased in terms of frequency and size to support the better functioning of the CP market. In addition, with a view to facilitating corporate financing during the run-up to the calendar and fiscal year-ends, the range of corporate bonds and loans on deeds accepted as eligible collateral has been expanded and, as a temporary measure, BBB-rated corporate bonds and loans on deeds have been included in eligible collateral. Furthermore, a decision was made to introduce a special operation to facilitate corporate financing, which will be implemented in early January. This special operation will enable financial institutions to obtain funds over the fiscal year-end with no explicit ceiling on the total funds available, although the maximum loans available to individual financial institutions will not exceed the value of the corporate debt pledged as collateral. Also, the interest rate on these funds will be set lower than corresponding market interest rates. With these measures, the Bank is aiming to support, in terms of funds availability and costs, the lending activities of financial institutions and transactions on the CP and corporate bond markets. In addition, given that the tightness in corporate financing may increase further during the run-up to the end of the fiscal year, the Bank decided, last week, to introduce outright purchases of CP as a temporary measure, and to investigate how other corporate financing instruments may be employed as a central bank. Since outright purchases of CP essentially undertake the credit risks of individual firms, they constitute an exceptional step taken by the central bank in light of the Bank's fundamental position that the main purpose of central bank operations is to provide liquidity. Looking back on the history of central banks in leading countries, the only cases where central banks have purchased corporate financing instruments outright are the Bank of Japan's purchasing of ABCP, ABSs, and corporate stocks in the first half of this decade and the Federal Reserve's purchasing of CP mentioned earlier. Nevertheless, it becomes difficult to draw a clear line between measures to provide liquidity and those that take on credit risk in crisis situations. Central banks are expected, based on the current economic and financial situation, to fully recognize the importance of their responsibilities in ensuring the stability of prices and of the financial system, and to make judgments on specific and practical matters in view of appropriately assuming these responsibilities. The Bank, in providing support to corporate financing, will examine the scope of undertakings that are necessary and appropriate for a central bank, as well as appropriate ways, including the involvement of the government, to ensure the Bank's financial health and confidence in the currency. Closing remarks Today, I have discussed the conditions of global financial markets and the world economy, the economic situation in Japan, and the conduct of monetary policy, and also presented some outlook for the coming year. Currently, the world economy is in a severe situation never experienced for many years that I may venture to call a crisis situation. The immediate task is "fire-fighting" against this crisis, and we are doing our utmost. At the same time, however, looking back on the developments in the world economy for the past two decades or so, the phenomenon of the rise and bursting of bubbles seems to have increased in frequency and become visible across a wider range of economies. Considering the background to these experiences, it seems necessary to remember that responding to crises with excessive policy actions may lead to larger crises later on. In the current crisis, many issues have surfaced in central banking circles in areas such as the basic ideas behind the conduct of monetary policy and the regulation and supervision of financial institutions. I am sure that various issues are also being reconsidered in the field of corporate management, given the progress of globalization in economic and financial activities. The Bank, through exchanging views with you, will do its utmost as a central bank to facilitate the return of Japan's economy to a sustainable growth path with price stability. Thank you very much for your kind attention.
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Statement by Mr Masaaki Shirakawa, Governor of the Bank of Japan, concerning the Bank's Semiannual Report on Currency and Monetary Control before the Committee on Financial Affairs, House of Councillors, Tokyo, 16 December 2008.
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Masaaki Shirakawa: Recent economic and financial developments in Japan Statement by Mr Masaaki Shirakawa, Governor of the Bank of Japan, concerning the Bank's Semiannual Report on Currency and Monetary Control before the Committee on Financial Affairs, House of Councillors, Tokyo, 16 December 2008. * * * Introduction The Bank of Japan submitted to the Diet its Semiannual Report on Currency and Monetary Control for the second half of fiscal 2007 on June 10, 2008 and that for the first half of fiscal 2008 on December 12, 2008. I am pleased to have this opportunity to present an overall review of the Bank's conduct of monetary policy. I. Developments in Japan's economy Japan's exports have decreased due to the slowdown in overseas economies. With the deterioration in corporate profits and households' employment and income situation, domestic private demand, particularly business fixed investment and private consumption, has weakened. In sum, Japan's economic activity has been increasingly sluggish. Indicators of production, employment, and private consumption have all been weak. The results of the Bank's December Tankan (Short-Term Economic Survey of Enterprises in Japan), which were released yesterday, also clearly indicated the severity of economic conditions in terms of business sentiment and fixed investment plans. On the price front, the three-month rate of decrease in domestic corporate goods prices has been large, mainly due to the drop in international commodity prices. The year-on-year rate of increase in the CPI (excluding fresh food) is around 2 percent against the background of the increase in prices of energy and food. CPI inflation is expected to moderate reflecting the declines in the prices of petroleum products and the stabilization of food prices. Regarding the financial side, investors have become increasingly risk averse reflecting disruptions in global financial markets. As a result, funding conditions in the CP and corporate bond markets have tightened, as indicated by the wider credit spreads on CP and corporate bonds and the difficulty faced by firms in issuing either. Moreover, an increasing number of firms, not only small but also large ones, have reported that their financial positions are tight and lending attitudes of financial institutions are severe. Thus, financial conditions in Japan are rapidly becoming less accommodative on the whole. There are risks to the outlook for economic activity and prices. Global financial markets remain under intense strain, although there has been some improvement in money markets in response to the various measures taken so far by governments and central banks. In this situation, due attention should be paid to the fact that there are downside risks to economic activity depending on developments in global financial markets and overseas economies. In addition, if financial conditions in Japan, as reflected in lending attitudes of financial institutions and issuing conditions in the CP and corporate bond markets, should increase in severity, pressures acting to depress economic activity from the financial side might become more marked. Turning to prices, there is a possibility that the inflation rate will decline further if downside risks to economic activity materialize or commodity prices fall further. II. Conduct of monetary policy As I have explained, the outlook for economic activity and prices is uncertain at present. In this situation, the Bank will carefully assess the future outlook for economic activity and prices, closely considering the likelihood of its projections as well as factors posing upside or downside risks, and will implement monetary policy appropriately. For the time being, it is particularly important to pay attention to downside risks to economic activity, such as those that may arise from developments in the U.S. and European financial systems and in global financial markets and the consequent downward pressure. Since early autumn, when the turmoil in global financial markets and in the U.S. and European financial systems increased in severity, the Bank has continued to make efforts, by employing various measures, to ensure market stability and maintain accommodative financial conditions. Specifically, against the background of the worldwide decline in U.S. dollar liquidity, the Bank introduced U.S. dollar funds-supplying operations as part of the coordinated measures of central banks in September and thereafter expanded such operations. As for yen funds, the Bank has introduced a complementary deposit facility to further facilitate the provision of sufficient liquidity, and has been providing funds for over the year-end with more frequency and in larger amounts than last year. In addition, the Bank has been actively purchasing CP and Japanese government securities under repurchase agreements, thereby ensuring market stability. Furthermore, with a view to facilitating corporate financing, the Bank has expanded the range of corporate bonds and loans on deeds it accepts as eligible collateral and has decided to introduce a new operation through which financial institutions can borrow low-interest funds from the Bank against corporate debt. Under this new operation, there will be no explicit ceiling on the total funds available, although the maximum loans available will not exceed the value of the corporate debt pledged as collateral. The Bank will continue to make efforts to ensure market stability by conducting appropriate money market operations such as the provision of sufficient funds during the run-up to the calendar and fiscal year-ends.
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Address by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Information Forum of the International Bankers Association, Tokyo, 27 January 2009.
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Masaaki Shirakawa: International banks amid global financial crisis Address by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Information Forum of the International Bankers Association, Tokyo, 27 January 2009. * 1. * * Introduction I am honored to be given the opportunity today to address the Information Forum of the International Bankers Association (IBA). I was told that this is the first time for the Governor of the Bank of Japan to address the Forum of this Association. And it might be an opportune moment, perhaps the most appropriate in your 25-year history, when the turmoil in global financial and capital markets remains and financial institutions and central banks are faced with various challenges. As an association of international financial groups, commercial banks, securities firms and representative offices in Japan, the International Bankers Association was established 25 years ago. Since then it has been making efforts to exchange views between member financial institutions and to enhance their dialogue with the Japanese authorities. Through those activities, the association has contributed substantially to the development of Japan’s economy and financial markets. Before starting my speech, I express my respect for the efforts you have been making over the years. In my speech today, I will briefly refer to the roles that international banks including other financial institutions play in Japan. I will, then, look back on the developments in financial markets at home and abroad since the collapse of Lehman Brothers, followed by policy responses by the Bank of Japan and lessons for the activities of international banks, especially the importance of liquidity management. In conclusion, I will touch on the roles and challenges of the Bank of Japan to ensure financial system stability. 2. Roles of international banks in Japan I begin with talking about the history of international banks in Japan. While the National Bank Act was enacted in Japan in 1872 and the Bank of Japan was established in 1882, international banks first operated in Japan in 1863, five years before the Meiji Restoration. Last year marked a memorable 150th anniversary of treaty of commerce between Japan and western countries, and for Japan that started international trade at the end of the Edo era, a means of trade settlement with overseas countries was needed first. At the time, it was the international banks in Japan that carried out the trade settlement functions by way of foreign exchange. Yukichi Fukuzawa, who is on a ten thousand yen bill and the leading educator toward the end of the Edo era and the Meiji era, sailed across the Pacific Ocean to the United States in 1860 as a member of an official mission of Japanese government. In his autobiography, he referred to an episode that cash bags filled with travel expenses were torn in a great storm and greenbacks were scattered inside the cabin. Only four years later, on a government’s mission to Europe in 1864, the international banks in Japan prepared foreign exchange money orders so that the mission members could cover their travel expenses without physically carrying cash. While it is only a small episode in the beginning of the modern banking system in Japan, it demonstrated that international banks were the pioneers of modern financial services in Japan. Since then, international banks have played important roles in Japan’s financial markets in various aspects including adoption of new financial techniques, discovery of new markets, and introduction of advanced risk management. In fact, while the share of international banks in loans and deposits only accounts for about one percent, the latest survey conducted in April 2007 showed that, the share of international banks was 67% in foreign exchange transactions and 68 % in derivatives transactions. The share is also high in call market funding and, especially before the outbreak of the subprime mortgage loan problem in the summer of 2007, it amounted to about 40%. The presence of international banks is also evident in terms of the banking operations of the Bank of Japan. The Bank currently has current account transactions with 64 banks and 18 securities firms which are from other countries. The international banks’ settlements using current accounts of the Bank are about 17 trillion yen in value and about 13,000 in number of transactions per business day, which are 13% and 25% of the total, respectively. Furthermore, international banks play a key role in daily open market operations by the Bank. For example, in the Bank’s primary funds-supplying operations against pooled collateral at the head office, there are 17 international banks in 39 eligible counterparties. At the same time, the increased presence of international banks suggests that the developments in overseas financial markets and the activities of overseas financial institutions are exerting a stronger influence than in the past on the host country’s economy. A good example is the recent developments in Central and Eastern European countries. In those countries, European banks outside the region have recently played important roles in the financial systems. However, amid the current crisis, those European banks’ lending to local firms declined rapidly and that partly accounted for the deterioration of economic activity in that region. Such situation is, to some degree, also relevant to Japan. International banks have been the dominant liquidity provider to Japan’s real estate market for the last several years. However, since around autumn 2007, real estate business of those international banks rapidly shrank, which led to a decline in transactions in the real estate market. In addition, international banks have been showing a strong presence in the field in which Japanese financial institutions have not been necessarily involved enough, such as securitization business, private equity business for bad loans, M&As, and long-term lending to local governments. However, the presence has been changing as international banks’ liquidity constraints have become acute. 3. Financial and capital markets since the collapse of Lehman Brothers Global economy and global financial markets Now let me turn to the developments in global financial and capital markets. Since the collapse of Lehman Brothers, the global economy and financial markets have changed dramatically. The fourth quarter figures for GDP, industrial production, and exports have started to be released in various countries, and a sharp decline that could be indeed expressed as “jump off a cliff” has been witnessed simultaneously worldwide. The Bank of Japan released last week the economic outlook, and the median forecast of Japan’s economic growth for fiscal 2009 among Policy Board members was substantially revised downward from 0.6% as of end-October 2008 to -2.0%. The principal factor behind the simultaneous and rapid slump of the global economy since autumn last year was the mounting global financial crisis triggered by the collapse of Lehman Brothers. The first phenomenon after the collapse of Lehman Brothers was the growing concern for counterparty risk in funding markets and associated malfunctioning of those markets. Consequently, the volume of transactions plunged and market liquidity declined not only in uncollateralized markets, but also in collateralized ones such as foreign exchange swap market. Against such a backdrop, the functioning of credit market declined, and private economic agents suffered in their fund-raising. Banks faced liquidity concern in addition to the losses and the capital shortage, and their lending stance became cautious. The declined functioning of the financial system exerted a negative impact on economic activity, which in turn adversely affected the asset quality of financial institutions and investors. What is happening now is the adverse feedback loop between the financial system and the economy. The global economy is facing difficult challenges, and such a situation is attributable to the phenomenon that leverages markedly increased around the globe in the periods preceding the current financial crisis. Consequently, what is necessary now is the unwinding of excessive leverages, or de-leveraging, so to speak. Without that, it is difficult to expect fullfledge recovery of the global economy. At the same time, if de-leveraging evolves rapidly and the provision of credit to private firms and household sector shrinks substantially, economic activity contracts sharply. To bring the global economy back onto a sustainable growth path, a delicate balance would be required between encouraging unwinding of excessive leveraging and preventing that unwinding from evolving too rapidly within a short period of time. Domestic financial markets The turmoil in global financial markets also had a substantial impact on Japan’s financial markets. Before the collapse of Lehman Brothers, both the short-term money market and the credit market in Japan were relatively stable, reflecting the fact that Japan’s financial institutions’ exposure to structural products was relatively small. Rather, such relative stability increased the attractiveness of Japan’s financial markets internationally as fund-raising markets, and yen funding by non-residents became active during the preceding periods up to the collapse of Lehman Brothers, as shown in issuing samurai bonds 40 percent more yearon-year basis. However, situation of domestic financial markets literally changed dramatically by the collapse of Lehman Brothers. The first change was the funding difficulties of international banks in the yen money market due to growing concern for counterparty risk. In the uncollateralized call market, funding by international banks became difficult amid declining market liquidity, and the two-tiering of interest rate emerged that the funding rates of international banks became higher relative to domestic financial institutions. Also in the collateralized money market, such as the repo market, the tendency to avoid transactions with international banks became widespread. After the burst of the bubble economy, concerns were expressed about the creditworthiness of Japan’s financial institutions in overseas markets and they faced a so-called Japan premium in dollar funding in late 1990s. The opposite took place this time. The second change is the distortion of pricing, or dislocation, due to the decline in market liquidity. That is obvious at a glance by looking at JGB’s yield curve, the pricing of the floating rate JGB and inflation-linked JGB, and swap spread which is the difference between the swap rate and JGB yield. Before the collapse of Lehman Brothers, international investors including hedge funds played a role of market liquidity provider through arbitrage transactions. However, after the collapse, their arbitrage transactions became inactive due to the decline in risk-taking capability, and market liquidity declined substantially. The third change is the declined functioning of domestic CP and corporate bond markets. In the CP market, issuance suddenly became difficult and the issuing rate has risen to a level above that of the financial crisis in 1998. In the corporate bond market, issuance by firms rated single A or below has virtually been suspended. In addition, the new issuance of samurai bonds, which had been steady up to last summer, remained almost suspended. 4. Policy responses by the Bank of Japan In response to those rapid changes in conditions, the Bank has been promptly taking various measures since last autumn. The measures taken by the Bank are classified broadly into three categories. The first category is the cut of the policy rate. The Bank lowered its target for the uncollateralized overnight call rate last October and December by 0.2 percent, respectively, to 0.1 percent. The second category is various measures to ensure financial market stability. The substantial provision of yen liquidity and US dollar funds-supplying operations fall into this category. The third category includes measures to facilitate corporate financing. Those include the expansion of eligible collateral related to corporate debts, and special funds-supplying operations to facilitate corporate financing, which are low interest rate funds-supplying operations against corporate debts as collateral. In addition, while extraordinary for a central bank, the Bank starts outright purchases of CP from the end of this month. While the measures I have just mentioned are all important, let me explain in more detail about the policy measures to maintain financial market stability and outright purchases of CP. Substantial liquidity provision to ensure stability of financial markets What is crucially important in a financial crisis is to maintain financial system stability. In that regard, Japan has a bitter experience. In autumn 1997, the default of a mid-sized securities firm in the interbank money market triggered rapid shrinking in market transactions. Once the confidence, which is basic premise of financial market transactions, collapses, its recovery takes time, resulting in substantial damage to the economy. The developments in global financial markets and the global economy since the collapse of Lehman Brothers bring me a sense of deja vu of what happened in Japan 10 years ago but on a worldwide scale. To maintain financial market stability amid financial crisis, substantial liquidity provision by a central bank is indispensable. In that regard, the Bank has taken various measures. First, the Bank has been striving for aggressive liquidity provision to maintain the stability of the domestic yen fund market. The introduction of a facility to pay interests on the reserves in October last year enabled the Bank to aggressively provide yen liquidity, without affecting the level of the call rate that is set based on monetary policy considerations. Second, the Bank started US dollar funds-supplying operations in Japan. The US dollar provision by central banks of countries other than the United States had been conducted by the European Central Bank and the Swiss National Bank since the end of 2007. Given that functioning of foreign exchange swap market also declined in Japan since the collapse of Lehman Brothers, the Bank started the US dollar-supplying operations, in close coordination with the U.S. and other major central banks. The Bank obtained necessary US dollars through swap transactions with the Federal Reserve. In the current global financial crisis, swap transactions between central banks have been used for securing non-dollar currencies as well, and, as a temporary measure until the end of April 2009, the Bank of Japan and the Bank of Korea increased the maximum amount of the bilateral yen-won swap arrangement from three billion US dollars equivalent to twenty billion US dollars equivalent. The temporary increase strengthened the Bank of Korea’s capacity to immediately supply yen funds when Korean financial institutions urgently need the yen. Measures to facilitate corporate financing For central banks, those liquidity provisions are orthodox responses to a financial crisis. By contrast, the outright purchases of CP entail an effect of facilitating corporate financing and containing the contraction of economic activity through mitigating the fear of liquidity dry-up, which firms worry. In fact, since the announcement of the measure in December, the issuing environment of CP has somewhat improved. However, the outright purchases of CP are an extraordinary measure in that a central bank directly shoulders credit risk of individual firms. The premise of free market economy is that central banks provide liquidity at large, and private financial institutions and financial markets perform the function of individual resources and credit allocations. For that reason, it is essential to clarify the basic principles in what cases a central bank carries out such extraordinary measures. The first principle is that a significant decline in the market functioning of corporate financing is observed, leading to tight corporate financing conditions on the whole. The second principle is that the outright purchases of corporate financing instruments are judged necessary in light of the Bank’s mission to ensure price stability and financial system stability. Even in the cases in which a central bank’s outright purchases of corporate financing instruments are judged as necessary, based on the principles I have just mentioned, very careful design is required in actual implementation. Deep involvement of a central bank in credit allocation of individual financial markets and individual firms might lead to a paradoxical consequence, such that markets which are functioning relatively normally would be impaired by the central bank’s own action. In that regard, it is not the case that more purchases are more effective. In addition, if the central bank incurs losses, it might undermine confidence of general public in the central bank’s policy conduct and ultimately in the currency. Keeping those points in mind, the Bank has laid out three elements to be considered. The first element is a perspective of neutrality, which prevents discretionary credit allocation to individual firms. The second is to conduct the purchases for a necessary period and on an appropriate scale. That would ensure that the purchases are a bridging measure until the market function recovers. The third is to ensure the Bank’s financial soundness. Since the losses of the purchases impose costs on taxpayers, it is important to avoid the concentration of credit risks in a specific firm. The specifics of the CP purchasing scheme is as follows. From the first perspective of neutrality for credit allocation, the Bank will purchase from financial institutions that are the counterparties of the Bank by fair and transparent means of competitive auctions. In addition, from the second perspective, the purchases will be conducted for a limited time up to March this year, and the Bank uses an auction in which somewhat a high minimum bid rate is set. The minimum bid rate is set to be more favorable than the market interest rates when the market is malfunctioning, but not more favorable than the market interest rates of normal times. With this setting, bids will naturally decrease in number as the market function recovers. In addition, from the third perspective of ensuring the Bank’s financial strength, the Bank will purchase a-1 rated CP that are eligible as the Bank’s collateral, with setting upper limits by each individual firm. Keeping in mind that the outright purchases could be a means of meeting firms’ funding needs including the redemption of corporate bonds toward the end of a fiscal year, the total amount to be purchased is set so as not to exceed three trillion yen and will be temporarily conducted until the end of March this year. The actual purchases of CP will start this month. In addition, the Bank is now considering the outright purchases of corporate bonds with a remaining maturity of up to one year. 5. Lessons for financial institutions’ international activities: importance of liquidity management Next, by changing the subject, in light of the impact of the current global financial crisis on financial institutions’ businesses, especially on international activities including those of overseas bases, let me consider what kind of lessons should be drawn. Here I focus on the importance of liquidity management, which is deemed particularly important. The importance of liquidity management The first lesson is that, it is necessary to keep remembering that a notion “liquidity is always there” would not hold. In retrospect, a situation that could be characterized as “abundant liquidity” continued for several years preceding the current crisis. Here, “abundant liquidity” does not only mean the level of cash, but also includes a sense of reassurance that one can obtain funds anytime and a sense of reassurance for market liquidity that financial assets can be sold anytime at prevailing market price. However, as the current financial crisis has shown, liquidity could suddenly dry up. Once liquidity concern arises, the forced selling of assets occurs as market participants rush to obtain fund liquidity, and the market price will diverge from the value of cash flow that the corresponding assets generate. That suggests that profits and capital position will be affected by the extent of liquidity as well. In designing business models, financial institutions need to recognize the possibility of liquidity dry-up. Liquidity management in overseas bases The second lesson is the importance of establishing a liquidity management system of international banks that conduct businesses at bases other than home countries. As mentioned before, liquidity cannot always be obtained, which reassures the importance of retail deposits that are relatively stable funding source. In that regard, for internationally active financial institutions, it would not be easy to take such retail deposits from customers in countries they operate. In terms of funding structure in Japan, international banks rely their funding on foreign exchange swaps, repo transactions, and fund transfer from head offices in home countries through intra-office accounts. In any event, the funding in currency other than home currency eventually depends heavily on funding conditions in the market. Such line of thinking suggests that it is extremely important that the foreign exchange swap market, which converts home currency into another country’s currency, is operating normally. The striking change in global financial markets after the collapse of Lehman Brothers was the decline in the functioning of not only the uncollateralized fund market but also of the foreign exchange swap market, which made it difficult to obtain funds in foreign currency, regardless of individual financial institution’s creditworthiness. Smooth liquiditiy management by a financial institution cannot be achieved only by using its own cash, deposits, and borrowing capability. It also depends on the condition of market liquidity of financial assets. However, if a financial institution tries to secure its liquidity level sufficient enough to cope with an extreme stress situation, the financial institution has to hold sizable amount of risk free and short-term financial assets and thus cannot pursue its intrinsic function of financial intermediation. In that context, liquidity management by a financial institution itself, market-level efforts to maintain market liquidity, and proper exercise of the lender of last resort function by a central bank, would be the three indispensable factors. With respect to liquidity management by a financial institution itself, the Basel Committee on Banking Supervision released a guidance paper on liquidity management last September, and there it presented sound practices for enhancing liquidity management by conducting appropriate liquidity management, including that of foreign currencies, according to the characteristics of each market in which financial institutions operate. Importance of improving market infrastructure The third lesson is the importance of improving the infrastructure of the market and the payment and settlement system, which is derived from the aforementioned perspective of maintaining market liquidity. The sudden collapse of Lehman Brothers brought a state of turmoil into the Japanese financial markets. In particular, the number of settlement failures increased in the JGB repo market, which contributed to declining liquidity in the JGB market. However, without the efforts in recent years by the market participants and the central banks to improve the infrastructure of the market and the payment and settlement system including the establishment of clearing mechanism in the securities market such as the Japan Government Bond Clearing Corporation (JGBCC), default in the repo market might have had a contagion effect on the entire JGB market and the market turmoil could have been much more severe. A good example is the scheme for foreign exchange settlement, which is called “CLS,” or Continuous Linked Settlement. The CLS links the payment systems of countries and makes a simultaneous payment of a pair of currencies associated with foreign exchange trading, which reduces foreign exchange settlement risk. While it is hard to win understanding in normal times, the experience since the collapse of Lehman Brothers suggests the importance of a scheme to properly manage counterparty risk. Given the current situation, its importance is recognized anew. At present, in order to reduce counterparty risk in the OTC derivatives trading, the discussion on establishing post- trading arrangements for derivatives has also started in Japan. The Bank expects private financial market participants to tackle those issues, and will also actively keep supporting the efforts of the market participants to improve the infrastructure of the market and the payment and settlement system and to review the market practices. 6. The role of the Bank of Japan toward financial system stability The current financial crisis has highlighted various issues and challenges about the conduct of monetary policy by central banks, and the role of financial institution supervision and regulation. Let me mention three points about the role of the Bank toward the stability of the economy and the financial system. A macroprudential perspective First is the importance to have a macroprudential perspective in the conduct of policies, be it monetary policy or regulation and supervision of financial institutions. To ensure financial system stability, the main premise is that financial institutions themselves manage risks. However, the risks inherent in the financial system do not necessarily equal the sum of the risks of individual financial institutions. Let me take an example of residential mortgagebacked securities (RMBSs), securitized products that have residential mortgages as underlying assets, which triggered the global financial crisis. For individual investors, the risks seem to be diversified, thanks to securitization technology, but, if housing prices decline on national basis, the risk diversification effect will not work. In addition, it cannot be ignored that market liquidity is supported by the entry of many investors attracted by the continuing increase in housing prices. In other words, in recognizing necessary amount of capital, financial institutions need to take into account liquidity as well. In that context, it is extremely important not only to monitor the individual risks of financial institutions or products, but also monitor the risks inherent in the financial system as a whole from a macroprudential perspective. In such recognition, the Bank has been recently making efforts to conduct research from a macroprudential perspective and disseminate information, and part of the efforts is contained in our Financial System Report. The Bank would like to continue to strengthen and exercise its macroprudential function. On-site examination and off-site monitoring Second is the importance of grasping precisely the conditions of individual financial institutions, together with holding a macroprudential perspective that I have just mentioned. Economic growth eventually materializes by combining labor and capital equipment in an optimal way and utilizing the fruits of technological innovation. The function of financial intermediation supports that process from the financial side. Given this line of thinking, it is important to steadily understand how funds are used for what purposes and, in doing so, whether financial institutions are conducting proper liquidity management. The Bank of Japan conducts both on-site examination and off-site monitoring, and for the central bank as a lender of last resort, the current crisis obviously showed the importance that the central bank has hands-on knowledge. In that regard, close liquidity monitoring by the Bank has been effective in maintaining the relative stability of Japan’s financial markets. In the case of international banks, the Bank’s on-site examination and off-site monitoring are conducted for their Japanese branches. However, to find out the potential risk factors and to properly evaluate their impact, the Bank needs to deepen the understanding of the financial groups’ entire management policy and risk management strategy, the status of the bases in Japan within the group, and the governance structure. For those who are here today, I would like to seek your understanding and cooperation, more than ever, on the importance of the Bank’s on-site and off-site monitoring. International cooperation Third is the importance of international cooperation. Major central banks have been closely exchanging views and information not only at Governor levels but also at staff levels with respects to various areas such as market operation, financial supervision, and settlement system. Such cooperation has become greater in the current crisis. The close cooperation is not only with the United States and Europe, but also with Asian countries. As expressed in the word “globalization,” it is true that financial markets are heading toward standardized and seamless ones. At the same time, it is also another fact that plenty of seam and lumpy factors remain. For that reason, the importance of information exchange and cooperation in the area of central banking business would be increasing further. The Bank of Japan would like to communicate closely with you, conduct appropriate policy responses, and actively support market participants’ efforts toward financial system stability. Your cooperation is highly appreciated. Thank you very much.
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Speech by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at a Meeting with Business Leaders, Tochigi, 29 January 2009.
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Kiyohiko G Nishimura: Recent economic and financial developments and the conduct of monetary policy Speech by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at a Meeting with Business Leaders, Tochigi, 29 January 2009. * * * Introduction The Bank of Japan regularly holds a meeting of this kind in various regions where a member of the Policy Board explains developments in Japan's economy and the thinking behind the conduct of monetary policy, and exchanges opinions with business leaders in the region. Today, I am much honored to have my first opportunity to visit Tochigi Prefecture and speak before business leaders here. I understand that our staff in the Research and Statistics Department and the Financial Systems and Bank Examination Department visit you frequently to collect information on the economic and financial situation of the region. The information is very valuable for accurately understanding Japan's economic and financial situation as well as for formulating the conduct of monetary policy. I would like to take this opportunity to thank you for your cooperation. Today, I would first like to explain the Bank's view on Japan's economic and financial situation and our thinking behind the conduct of monetary policy. The Bank publishes semiannually, in April and October, a document called Outlook for Economic Activity and Prices, which explains the Bank's economic outlook and its thinking behind the conduct of monetary policy, and three months after its publication, in July and January, mid-term assessments of the projections are conducted. We just conducted a midterm assessment at the Monetary Policy Meeting (MPM) held last week, and revised the projected growth rates and inflation rates significantly downward. To explain the reasons for this downward revision, I must begin by discussing the financial crises in the United States and Western Europe as well as the deceleration in overseas economies, which are major factors responsible for the deterioration in Japan's economic conditions. Then I would like to proceed to Japan's financial conditions, the current situation of and outlook for Japan's economy, and the Bank's policy responses. I. The U.S. and Western European financial crises and the deceleration in overseas economies The turmoil in global financial markets stemming from the subprime mortgage problem in the United States was exacerbated by the bankruptcy of Lehman Brothers in September 2008. The turmoil has advanced to become a financial crisis where not only U.S. but Western European financial institutions either failed or faced severe difficulties. Currently, the influence of the financial crisis is spreading to emerging economies in regions such as Central and Eastern Europe and Latin America. As a result, economic conditions are deteriorating globally: emerging economies that had continued to show high growth are experiencing a decline in exports reflecting the deterioration in the U.S. and Western European economies, and the impact of the financial crisis is taking its toll on internal demand in emerging economies, leading to a clear deceleration in economic activity. Another distinctive feature of the current deceleration is the speed with which financial crises spread and economic conditions deteriorate. Since the world economy has never experienced such sudden changes before, this is further increasing future uncertainty and has led to a further deterioration in economic conditions. The largest factor contributing to this rapid and simultaneous deterioration in world economic conditions is the progress of globalization in financial and economic activity. The widespread use and popularization of advanced technology in information and communications have supported globalization through increased speed of transactions, reductions in the interregional information gap, and a global network of transactions. Paradoxically, one cannot deny that once financial transactions and economic activity supported by these advanced information and communications technologies decrease, this causes a sudden unwinding. With respect to financial activity, financial institutions around the world are currently utilizing these advanced information and communications technologies to carry out a large volume of cross-border financial transactions and invest in a variety of financial assets. The direct causes of the U.S. subprime loan problem leading to balance-sheet constraints and failures of Western European financial institutions were their large investment in securitized products backed by U.S. subprime mortgage loans and their commitment to provide backstop liquidity, just as in the case of U.S. institutions. While the deterioration of economic conditions in the United States and Western Europe and the increase in bad assets were gradually proceeding, Lehman Brothers went bankrupt, triggering a sharp decline of confidence in U.S. and European financial institutions, which are mutually involved in a web of complex trade, and this led to a chain of failures and poor performance of financial institutions in the United States and Western Europe. In addition, these financial institutions had an important role channeling funds to emerging economies in regions such as Central and Eastern Europe and in Latin America. With the outbreak of financial crises in the United States and Western Europe, these institutions suddenly scaled back their exposures to emerging economies, creating problems for these economies too. With respect to economic activity, the progress of globalization increased the role of emerging economies not only as production bases for the leading economies but also as a huge market for the latter's own products. Given this increased presence in the global marketplace, emerging economies are now faced with a marked decrease in internal demand due to declining exports reflecting a downturn in the U.S. and Western European economies and downward pressure from the financial side as a consequence of financial crises in the United States and Western Europe. With the widespread use and popularization of advanced information and communications technologies, these developments are taking place at a speed not imaginable in the past. As a manager of a manufacturing firm has stated, "Demand has evaporated in a market where, until recently, supply could not keep up with the increase in demand." With the clear deceleration in growth of emerging economies, exports to them from the United States and Western Europe are decreasing, adding further downward pressure on economic activity there. And this is causing in turn a further decline in exports from emerging economies, subsequently decreasing internal demand in these economies. Currently, there are two adverse feedback loops operating globally and leading to a sharp deterioration in world economic conditions: one where a decrease in production, income, and expenditure takes place in a spiral with a decrease in exports as a starting point, and another where negative developments in financial and economic activity mutually reinforce each other. Confronted with a sharp global deterioration in financial and economic conditions, governments and central banks have taken various measures. To alleviate the economic downturn, considerable monetary easing and fiscal stimulus have been enacted in many countries. To alleviate the financial crisis, central banks in various countries are providing funds not only in their own currency but in U.S. dollars as a concerted action. Governments are placing troubled financial institutions under their control, injecting public funds, expanding their deposit insurance schemes, and insuring the liabilities of financial institutions. In spite of these successive expeditious measures taken by governments and central banks, there are still uncertainties as to how the financial crises in the United States and Western Europe will be resolved and how the world economy will recover. With the adverse feedback loop operating between financial and economic activity, losses incurred by financial institutions and the amounts of capital that need to be raised tend to increase as time passes, and it is not clear whether the actions taken so far are sufficient to deal with the problem. For the financial system to regain stability, the amount of losses that financial institutions will incur needs to be clarified and the institutions need to be sure that the amount of capital they hold is enough to cover these losses. Since it is not clear that these conditions are met, a high level of uncertainty remains regarding how the financial crises will be resolved. With regard to the recovery of the world economy, a turning point will arrive when adjustments in asset prices proceed in major economies, recovery in total demand is foreseen, and pressures acting to depress economic activity from the financial side dissipate with the progress in stabilizing the financial system. Although we expect these signs of recovery to emerge by the latter half of this fiscal year, the timing of recovery in the world economy remains highly uncertain since it is unclear how financial crises will be resolved. II. Financial conditions Japan's economy, until recently, was not burdened by excesses in production capacity and labor, and the financial system remained relatively stable. Therefore, it was thought to be resilient against supply and demand shocks as long as they remained local. However, with multiple shocks hitting the world economy like tidal waves since last autumn, Japan's economic conditions have deteriorated sharply. In the last several years, Japan has developed a growth mechanism based on increases in global demand – especially for automobiles and capital equipment – but decreases in exports of these goods, due to a sharp deterioration in world economic conditions, have led to a substantial decline in production, income, and labor. The decline was also augmented by increased tightness in Japan's financial conditions. With regard to firms' funding costs, while bank lending rates have decreased somewhat owing in part to the reductions in the policy interest rate, credit spreads on CP and corporate bonds remain elevated reflecting strong risk aversion worldwide among investors. As a result, funding costs of firms as a whole have remained mostly unchanged. With regard to the amount of funds available, the amount outstanding of CP and corporate bonds issued is currently substantially less than a year ago due to the deterioration in issuing conditions, and demand for bank lending is rising sharply due to firms' strong desire for ample liquidity to hoard in view of increased future uncertainty. Financial institutions, while examining borrowers' creditworthiness and past business relations with them, have been attentive to these funding needs. In addition, an increasing number of financial institutions are utilizing the emergency guarantee scheme introduced by the government to provide lending to small firms with growing funding needs due to deterioration in their business conditions. Bank lending, therefore, rose through the end of last year to exceed, in November and December, the highest year-on-year rate of increase recorded since the publication of such statistics began. With stock prices remaining low and economic conditions deteriorating sharply, financial institutions are becoming increasingly conscious of future rises in credit costs as well as their capital constraints. This is further worsening the severity of financial institutions' lending attitudes. Also in the area of trade credits, small firms are facing tighter settlement conditions. With the tightening of financial conditions and the decline in corporate profits, an increasing number of firms are indicating that their funding conditions are severe, and are scaling down their fixed investment plans. In this sense, an adverse feedback loop between economic and financial activity is starting to operate in Japan. In addition to the state of the financial crises in the United States and Western Europe and the degree of recovery in the world economy, the appropriateness of the level of capital held by Japanese financial institutions will also be important in judging how financial conditions will change and whether the adverse feedback loop between financial and economic activity will intensify. In Japan, bank lending accounts for the majority of corporate funding. Banks also serve an important role in direct financing, since they underwrite a large proportion of CP and corporate bonds issued by firms. Therefore, the amount of risk that banks can assume becomes an important issue. In other words, given that banks' capacity to take on risk is determined by the level of capital they hold, whether that level is sufficient has an important bearing on developments in corporate financing. This could be conceptually summarized as follows. Even if the business condition of banks deteriorates and losses expand, the financial intermediary function of banks will not be harmed as long as losses can be sufficiently absorbed by capital. In other words, capital serves as a buffer in the financial intermediary function. If, however, the ratio of losses to capital exceeds a certain critical point, there is a possibility that the financial intermediary function will become significantly impaired; in other words, the relationship between the scale of capital and the financial intermediary function is nonlinear. This was observed after the economic bubble burst in Japan. For several years, the workings of the financial intermediary function did not become an issue, although increases in nonperforming loans were recognized as a big problem. However, in the latter half of the 1990s, a credit crunch materialized where lending could not be increased due to capital constraints. With regard to the current situation of the financial system in Japan, the level of capital held by financial institutions, or their capital strength, remains adequate on the whole. This is very different from the situation in the United States and Western Europe, where large-scale capital injection of public funds into a wide range of financial institutions became necessary. Also, the situation in Japan is currently quite different from that in a credit crunch, where financial intermediation becomes largely dysfunctional. Having said this, global financial markets still remain under significant strain and this is gradually affecting Japanese financial institutions as well as their financial intermediary function through declines in stock prices and increases in credit costs, although the degree may differ with the institution. This reinforces the argument for strengthening the capital base of financial institutions and is the background against which an institutional framework embodied in the Act on Special Measures for Strengthening Financial Functions is being prepared. The Bank will be closely monitoring the capital conditions of financial institutions and developments in the financial intermediary function. III. Outlook for Japan's economy I will now turn to the outlook for Japan's economy. As I said earlier, economic conditions in Japan have deteriorated significantly due to a substantial decrease in exports, reflecting a slowdown in overseas economies and the resultant adverse effects on domestic demand, and also to tighter financial conditions, and they are likely to continue deteriorating for the time being. Uncertainty about the prospects for Japan's economy continues to be extremely high, but the Bank's baseline scenario is that the economy will start recovering as global financial markets regain stability and overseas economies move out of their deceleration phase. The timing of recovery, however, is likely to be no sooner than the latter half of fiscal 2009. Based on the interim assessment made at the MPM held on January 21 and 22, 2009, the growth rate of real GDP on a fiscal-year basis is projected to be negative for two consecutive years, recording minus 1.8 percent in fiscal 2008 and minus 2.0 percent in fiscal 2009. The growth rate is unlikely to recover to its potential until fiscal 2010. The outlook for Japan's economy relies heavily on the recovery of overseas economies, the stability of global financial markets, firms' medium- to long-term growth expectations, and financial conditions in Japan. Depending on developments in financial conditions worldwide, overseas economies, medium- to long-term inflation expectations, or Japanese financial conditions, growth rates may turn out lower than expected. With regard to inflation, the consumer price index (CPI) inflation rate, which had been around 0 percent since around 2003, rose at a rapid pace from around the end of 2007 reflecting increases in the prices of petroleum products and food due to the surge in commodity prices, and reached 2.4 percent last summer. Thereafter, it began to decline at a rapid pace reflecting a significant drop in commodity prices, and recorded 1.0 percent in November 2008. Looking ahead, it is expected to continue its sharp downtrend and turn negative due to increasing slackness in domestic supply and demand conditions in addition to the declines in the prices of petroleum products and the stabilization of food prices. The CPI inflation rate is projected to record a decline of around 1 percent in fiscal 2009. Thereafter, the rate of decline is expected to diminish gradually through fiscal 2010 as the economy returns to a sustainable growth path. Given that the CPI inflation rate will likely remain negative through fiscal 2010, one question that may be raised is whether this decline in prices will lead to a deflationary spiral – a situation in which a decline in prices induces a further decline, thereby accelerating the pace of decline and at the same time adversely affecting economic activity. If households expect wide-ranging price declines, they will reduce consumption, and this in turn will accelerate the decrease in demand. If firms expect their competitors to reduce prices on a broad range of products, they have no choice but to reduce their prices, and this may decrease firms' profitability further. However, the most important factor in assessing whether a deflationary spiral will materialize is not the short-term inflation expectations, which have been affected by the rapid changes in commodity prices, but developments in the medium- to long-term inflation expectations of households and firms. During the last twelve months, they have remained mostly unchanged, little affected by last year's rise or the recent rapid decline in the inflation rate. If the inflation rate remains negative for a protracted period, however, there is a risk of a gradual decline in medium- to long-term inflation expectations. Future developments in medium- to long-term inflation expectations should therefore continue to be monitored closely. IV. Conduct of monetary policy Next, I will talk about the Bank's conduct of monetary policy. As I said earlier, economic conditions in Japan have deteriorated significantly. In response to the economic situation and its weaker prospects, the Bank reduced its policy interest rate to 0.3 percent from 0.5 percent at the end of October 2008, and reduced it again to 0.1 percent in December. To produce maximal effects of reductions in the policy interest rate, it is a necessary precondition that markets function in a stable and smooth manner. From this viewpoint, the Bank has been taking various policy actions. The first is to ensure stability in money markets by providing liquidity. In addition to the substantial provision of liquidity in yen, the Bank has been providing liquidity in U.S. dollars without limitation on the amount, as long as it is within the value of collateral, under an internationally coordinated framework. Furthermore, in December 2008 the Bank increased its outright purchases of Japanese government bonds (JGBs) from 14.4 trillion yen per year to 16.8 trillion yen per year. In order to supply funds more smoothly, provision of longer-term funds is desirable rather than providing short-term funds through frequent operations. Hence, the Bank decided to increase its outright purchases of JGBs, which provide longer-term funds. The second policy action comprises measures to facilitate corporate financing. Since last fall, when financial conditions began to tighten, the Bank has been taking various measures with a view to making it easier for firms to obtain funds. The Bank has for some time been conducting purchases of CP under repurchase agreements, and these have been significantly increased in terms of frequency and size to support the better functioning of the CP market. In addition, with a view to facilitating corporate financing during the run-up to the calendar and fiscal year-ends, the range of corporate bonds and loans on deeds accepted as eligible collateral was expanded in early December 2008 and it was decided, as a temporary measure, to include BBB-rated corporate bonds and loans on deeds in eligible collateral. Furthermore, a decision was made to introduce a special operation to facilitate corporate financing, starting in early January. This special operation enables financial institutions to obtain funds over the fiscal year-end with no explicit ceiling on the total funds available, although the maximum loan available to an individual financial institution will not exceed the value of the corporate debt it has pledged as collateral. In addition, the interest rate on these funds is set lower than the corresponding market interest rates. With these measures, the Bank is aiming to support, in terms of the availability and cost of funds, the lending activity of financial institutions and transactions on the CP and corporate bond markets. In addition, given that the environment surrounding corporate financing had deteriorated and the tightness in corporate financing might increase further during the run-up to the end of the fiscal year, the Bank decided, in mid-December 2008, to introduce outright purchases of CP from financial institutions, and to investigate additional measures. However, since these measures involve taking on the credit risks of individual firms, they represent an exceptional step for a central bank, and when taking such a step, a central bank should of course implement measures that have maximal effects in terms of facilitating corporate financing. At the same time, however, it should also consider possible actions to be taken should losses occur, so that the Bank's financial health and confidence in the currency and in monetary policy are not impaired. After close investigation of the present environment surrounding corporate financing and careful examination of the range of CP to be accepted under this exceptional measure and the measure's duration, the Bank decided, at the MPM held on January 21 and 22, 2009, to introduce outright purchases of CP and asset-backed CP (ABCP) for a total outstanding amount not exceeding 3 trillion yen until the end of March 2009. If the Bank purchases CP from financial institutions, this gives them additional capacity to accept more CP, which would improve the functioning of the CP market, or to increase lending, including that to small firms. The underlying assets of ABCP are mainly credit receivables, loans, and bills, and the Bank's outright purchases of ABCP are therefore expected to contribute to facilitating corporate financing, especially among small firms. The Bank also decided to accept, when providing funds to financial institutions, bonds, such as J-REIT bonds, issued by real estate investment corporations as collateral. Through this measure, the Bank expects the market liquidity of these products to increase, leading to better functioning of the real estate securitization market. In addition to the measures just described, the Bank decided to examine practical ways to introduce outright purchases of corporate bonds. Corporate bonds are debts with longer maturities than CP, and thus outright purchases by a central bank involve taking on the credit risks of individual firms for a longer term than in the case of CP. In order to prevent outright purchases of corporate bonds from adversely affecting long-term resource allocation in individual firms and avoid prolonging markets' dependence on the central bank as a buyer, a central bank should only purchase corporate bonds with a short residual maturity and purchase them from financial institutions that are counterparties of the central bank instead of purchasing directly from the issuers. Bearing these factors in mind, the Bank intends to purchase corporate bonds with a residual maturity of up to one year, and will decide on the specifics of this measure as swiftly as possible after careful examination. As I mentioned earlier, to deal with increasing demand for funds during the run-up to the calendar and fiscal year-ends, the Bank has been providing substantial liquidity to stabilize financial markets. And to deal with tighter conditions in corporate financing, the Bank implemented various measures, including the introduction of a new operation, to facilitate corporate funding, and to exert influence upon the formation of longer-term interest rates, which are the actual interest rates that apply when funds are acquired. The Bank will continue to carefully assess economic and financial conditions and do its utmost as a central bank by introducing the monetary policy measures that it judges most effective. Closing remarks: toward a new path of growth for Japan's economy You may have the impression that newspaper articles and television news and even my speech today communicate nothing but the severity of the current economic and financial conditions. In a situation like the current one, where changes in global financial markets and in overseas economies come flooding in all at once like tidal waves, one tends to lose sight of the broad picture and focus only on recent events. In closing, therefore, I would like to give my brief overview of the current situation. As I mentioned at the beginning of my speech, innovation in information and communications technology made great strides from the latter half of the 20th century through the early 21st century, and globalization progressed based on the rapid entry of a growing number of emerging economies into the world of market economies made possible by these advances. As a result, the supply of goods increased due to the added production in regions newly integrated in the world of market economies, and at the same time, economic development in these regions increased demand for goods and financial assets. This generated increased business opportunities in the markets for goods and financial assets, and accelerated the growth of the world economy. However, such an environment is likely to invite an accumulation of various excesses and imbalances. Thus, the situation we are currently facing can be explained as a sudden reversal of a rapid growth process that depended heavily on excesses and imbalances. Looking back, while overseas economies had been increasing their growth rates by taking advantage of globalization, Japan's economy was still suffering from the aftereffects of the bubble economy of the 1980s. Japanese industries, with the exception of exporting industries, were not able to benefit from the growth mechanism based on the progress of globalization. This means, however, that excesses and imbalances inherent in Japan's economy are small relative to those of the economies that fully enjoyed the benefits of globalization, and they require only moderate adjustments. If Japan can redefine its area of comparative advantage and implement measures to strengthen these areas, Japan's economy is likely to show its true worth when overseas economies return to a recovery path. There are two requirements for this to be realized. First, Japan should protect and strengthen the areas where it has an advantage. Japan has an edge in manufacturing in a broad sense, especially where coordination is necessary. For example, in the process of producing an automobile, parts makers and the assembler discuss various ideas and techniques to make improvements. The quality of the final product is thus improved and at the same time productivity is increased to reduce costs. Demanding that parts makers reduce costs without providing any support in increasing productivity would just be forcing them to bear an additional burden. This is not the way Japanese manufacturers increase the value of products. Increasing the value of products is important in non-manufacturing industries too. For example, I was informed by a retailer that, with a slight change of focus in its sales strategy, it came up with the idea of selling goods that were easy for the elderly to use and that these became big sellers. This made me realize the importance of going back to the basic idea that value is created by a continuous accumulation of improvements. I believe that such strenuous efforts will be rewarded when the world economy returns to a recovery path. Second, Japan should directly confront and tackle current problems. Although the problems are numerous, it can be said that this is due to the fact that Japan is one of the world's leading economies. Solving the problems will bring about technological innovation that will give Japan's manufacturing industry a more prominent place in the world economy. Japan has an aging population, and there must be a need for innovative new products that turn this to advantage, such as automobiles with increased safety so that the elderly, with decreased physical functioning, can drive them safely and easily. Japan also faces environmental problems such as global warming as well as water and air pollution. Technological innovation that contributes to solving these problems will definitely help to increase Japanese firms' competitiveness. Tochigi Prefecture has a history of achievement in manufacturing, and the prefecture's strength in manufacturing has been supporting an expansion into a wide range of fields. Many firms in the prefecture have the top market share in Japan in technologically advanced products, for example, medical and optical equipment, and I am aware of efforts to further develop and strengthen these fields through cooperation between industry, government, and academia. I hope that these efforts will bear fruit, and lead to a recovery of Japan's economy and positive new developments in the future. The Bank is determined to support these movements through appropriate conduct of monetary policy. Thank you very much for your kind attention.
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Address by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Fourth Deposit Insurance Corporation of Japan Round Table, Tokyo, 25 February 2009.
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Masaaki Shirakawa: Coping with financial crisis – Japan’s experiences and current global financial crisis Address by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Fourth Deposit Insurance Corporation of Japan Round Table, Tokyo, 25 February 2009. * * * Introduction I am much honored to be invited to address the 4th Deposit Insurance Corporation of Japan Round Table in Tokyo. As you are well aware, the global financial system is unstable due to the burst of the global credit bubble. In particular, global financial markets have been under severe strain since the collapse of Lehman Brothers last autumn. Both the central bank and the deposit insurance corporation do not draw much attention under normal circumstances, and their presence stands out only when depositors and financial market participants do not have full confidence in the soundness of financial institutions and financial system stability. Today, the activities of the deposit insurance corporation and the central bank draw much attention from the public, and that is a testament that we are facing difficult challenges. From a longer-term perspective, it was in the early 1990s when the activities of the Deposit Insurance Corporation of Japan, hereafter DICJ, started to draw attention from the public and the media, and the financial assistance by the DICJ was carried out in 1991 for the first time in its history. At the time, the Deputy Governor of the Bank of Japan was an ex-officio Governor of the DICJ, and I, as a staffer at the Financial System Department of the Bank of Japan, had an opportunity to be deeply involved in the process in which the financial assistance was actually utilized. As events unfolded, Japan had to handle more severe financial crisis since the latter half of the 1990s. Through those experiences, it was shown how critical various functions of the deposit insurance system were in achieving financial system stability. In my address today, I will express my views on how to cope with a financial crisis by comparing Japan’s experience and the current global financial crisis. 1. Financial crisis in Japan after the burst of the bubble During Japan’s financial crisis, while real estate prices varied according to the region and the usage, the representative index plunged to almost a quarter of its peak. Banks played a predominant role in financial intermediation, and Japanese banks incurred cumulative losses of some 110 trillion yen, equivalent to 20 percent of Japan's GDP. It was after 2003 that Japanese banks’ capital strength and profitability bottomed out and the stability and functioning of the financial system started to improve, when Japan’s economy returned to a full-fledged recovery path supported by the global economic growth. In the meantime, the average growth of Japan’s economy had been stagnant, compared with the previous decades. While the economy of this period is often called as “Japan’s lost decade”, in my view, such a categorization might not be perfectly capturing the nature of the problem and challenges of policy measures taken to cope with a financial crisis. I will touch on this issue later, but it is true that it took a prolonged period of time for Japan to return to a full-fledged recovery path after the burst of the bubble. Today, I will emphasize three points focusing on policy responses on the financial system front, although we also have to examine the macroeconomic policy responses in order to make a comprehensive analysis of how to cope with a financial crisis. First, there was a delay in recognizing the severity of the impact of massive nonperforming assets on the economy. It was a few years after the burst of the bubble when we recognized how seriously the decline in real estate prices affected financial institutions. However, we lagged behind in recognizing how powerful the macroeconomic significance of the impact – or to borrow the recently much talked-about expression, “an adverse feedback loop between the financial system and the real economy” – could be. Second, there were imperfections in accounting and disclosure standards. At present, vigorous discussions are going on about how to cover the expected losses over the credit cycle in terms of accounting. At the time, there was a lag in showing the incurred losses of financial institutions on the accounting and disclosure front. Partly because of that, there was only an insufficient incentive mechanism at play to urge banks to promptly address the nonperforming asset problem. Third, partly as a result of the aforementioned two points, the authorities could not resolve troubled financial institutions in a timely manner, because of the delayed progress in establishing a framework of resolution to cope with troubled and failed large financial institutions. Arguably, the legal framework of resolution, operational procedure, and, above all, public funds to cover a capital shortage are vital in ensuring the smooth resolution of troubled and failed financial institutions. And it was in early 1998 after we experienced a series of failures of large financial institutions that the full-fledged safety net framework was put in place. It is clear in my memory that, the DICJ in the meantime had been tackling the resolution of failed financial institutions by making full use of what it had in its arsenal. Until the safety net framework was established, there were some cases that the Bank of Japan also played an unconventional role as a central bank in dealing with failed financial institutions by injecting its money as capital. 2. Current global financial crisis In light of our experiences during the financial crisis in Japan, the development of the current global financial crisis gives me a surprising sense of déjà vu. Until recently, Japan’s financial crisis has been considered as an isolated event unique to Japan. It appears that people around the globe are gradually coming to understand the implications of the massive credit bubble and its burst through the bitter experience during the current crisis. First, in terms of “the recognition of the problem”, for example, the estimate by the IMF on the total losses on U.S. credit-related debts has been increasing as time went. That typically suggests that the impact of an adverse feedback loop between the financial system and the real economy has also been underestimated in the current crisis. Second, there have been the issues related to accounting and disclosure standards. While the standards have improved compared with those of Japan in the 1990s, there are some new issues. Those include how to evaluate complicated structured products whose market liquidity is extremely low, and how to incorporate off-balance sheet vehicles. In addition, the traditional issues also persist. The nonperforming asset problem of U.S. and European financial institutions appears to have been gradually shifting to a traditional problem of loans on the banking book. The difficulty of evaluating the loan asset value, when the adverse feedback loop between the financial system and the real economy is at play, seems to be an unflagging issue at any time. Third, the framework to deal with troubled financial institutions was not well-equipped. It can hardly be said that the process of the disposal of the Northern Rock and Lehman Brothers was carried out within the sufficiently robust institutional framework. Even if such framework was in place, public capital injection into financial institutions is unpopular among the public in any country. In addition, there is a stigma on the part of financial institution to apply for injection of public capital. Furthermore, it is also a daunting task to identify the amount of losses incurred by financial institutions, which is the precondition for public capital injection. Those were all the difficulties that Japan actually confronted. 3. Measures addressing the liquidity problem I will now turn to the policy responses when a financial crisis takes place. As I have just mentioned, there are many similarities between Japan’s financial crisis and the current global financial crisis. Nevertheless, we are not likely to find a “one-size-fits-all” solution. Therefore, let me point out that what I describe from now will be an attempt to present a conceptual underpinning. Both in the cases of Japan after the burst of the bubble and the current global financial crisis, the crisis always surfaced in the form of liquidity shortage. In Japan, the default of a midsized securities firm in the interbank money market, despite the small amount of default, triggered a steep liquidity contraction in the money market and led to turmoil in Japan’s financial system as a whole. In the current financial crisis, after the severity of the creditrelated debt problem surfaced in August 2007, U.S. and European financial institutions faced a liquidity shortage, and the collapse of Lehman Brothers further exacerbated the conditions in the funding markets. As such, while a lack of liquidity was the starting point of the problem, the root cause of the problem was an issue of the solvency of financial institutions. In the early phase of a crisis, it is difficult to recognize how serious the liquidity problem is and how serious the solvency problem is. In case it is purely a liquidity problem, which is a relatively idyllic case, the central bank plays a role as “the lender of last resort” based on classical Bagehot’s principle. If it is likely that the problem is not a pure liquidity problem but a solvency problem from a system-wide perspective, there would be various challenges in carrying out policy responses in a timely manner. In such a case, while the central bank prevents the financial system from further destabilizing through aggressive liquidity provision, the financial institutions should identify their incurred losses and need to cover the capital shortages in the market, and the government ought to carry out public capital injection when the capital raising turns out to be insufficient. Put that in the context of the current global financial crisis, concern over counterparty risks intensified to an extraordinary level after the collapse of Lehman Brothers. And not only the confidence of depositors declined but also interbank money markets faced malfunctioning, where a high degree of mutual trust between the participants is a prerequisite. Once confidence collapses, the restoration of confidence becomes a top priority. In that regard, several countries expanded the coverage of deposit insurance and provided a government guarantee for financial institutions’ funding in the markets. Those measures were indeed effective. The deposit insurance system is intended to ensure bank depositors’ confidence through protecting deposits up to a predetermined amount. In the current crisis, the expansion of the coverage of deposit insurance indeed had effects of stabilizing depositors’ behaviors to some extent. Moreover, central banks have been trying to stabilize global financial markets by making extraordinary arrangements to provide liquidity to the markets in the U.S. dollar together with their own currencies. Through those measures, the funding conditions of U.S. and European financial institutions have been eased to some extent, compared with the situation immediately after the collapse of Lehman Brothers. However, as each government decided to introduce a guarantee scheme and the expansion of deposit insurance coverage, it created some unintended problems. The international flow of funds has changed, and some sound financial institutions that were in no need of receiving government guarantees have faced unfavorable funding conditions. While Japan has not introduced a government guarantee scheme, fund-raising by international financial institutions that received government guarantees, in off-shore markets or in the Samurai bond market in Tokyo, has adversely affected the corporate bond issuance of Japanese firms in the yen-denominated bond markets. In addition, in Japan’s interbank money market, it took some time for international financial institutions to raise funds easily, because the coverage and the procedure of a government guarantee were not clearly recognized by market participants. In that regard, during the financial crisis since the late 1990s, Japan adopted a blanket guarantee of all liabilities of financial institutions. While that was an extraordinary measure, it was quite effective in averting the collapse of the financial system. 4. Restoration of solvency Together with policy measures on the liquidity front, measures to restore solvency are of vital importance in a financial crisis. In the current global financial crisis, several measures have been already taken since last autumn to restore the solvency of financial institutions by using public capital. Those measures have proved to be effective. Nevertheless, there have been some cases in which financial institutions that received public funds continued to face weak stock prices and widening CDS premiums, and thus needed to have the second round of public capital injections. In those cases, it could be pointed out that pricing of structured products has become difficult, due to the decline in market liquidity, and the quality of loans continues to deteriorate because of the adverse feedback loop between the financial system and the real economy. A “mirage” phenomenon is taking place in that, despite public capital injection, concern over additional losses on the assets mounts over time and such concern in turn will heighten concern for a capital shortage of financial institutions. Under those circumstances, it is of vital importance to remove uncertainty. There are two options to remove uncertainty stemming from financial institutions’ nonperforming assets; the government purchases those assets or provides a loss guarantee to those assets. Nevertheless, even in both cases, uncertainty might not be removed for the assets not covered by the purchases or the guarantees, and investors thus would continue to ask the institutions for high risk premiums. Consequently, the institutions might not be able to fully restore confidence in the market. In addition, there are also other difficulties; how to set the selling price of the nonperforming assets in the case of asset purchase scheme and how to set the fee in the case of guarantee scheme. What Japan faced in the past and what the U.S. is facing now is arguably those difficulties. However, even with such difficulties, it is an indispensable process to promptly identify the amount of losses and to carry out recapitalization to secure financial system stability, if necessary. It should be noted that new issues have emerged in the global financial system as public capital injection prevails. One of them is a gap between the level of capital recorded on the balance sheet and market participants’ perception of franchise value of financial institutions. The level of capital presumably should reflect market expectations about earning growth potential of a firm. On one hand, recapitalization by the government serves as a buffer for future losses, in the same way with privately raised capital. On the other hand, it comes from different incentives from private capital, in which investors shoulder the risk with an expectation to recoup their investments by the future growth of the firm. In addition, if people increasingly tend to judge the soundness of a financial institution simply by looking at the level of capital on the balance sheet – in other words, looking at the capacity to absorb future losses rather than the earning growth potential –, a financial institution could face a paradoxical situation. A financial institution which does not accept public capital because of its financial soundness might suffer a competitive disadvantage against another institution which accepts public capital, because the sound institution has a lower capital adequacy ratio as a result. Furthermore, if many financial institutions intend to raise regulatory capital adequacy ratios at this juncture in order to avoid such disadvantage, the real economy will be adversely affected. When reviewing financial regulation and supervision in the future, the role of capital regulation will definitely be an important issue on the agenda. Aside from such a general point, it is also necessary to take into account that, during a financial crisis, the regulatory framework of capital adequacy ratio should not amplify pro-cyclicality. Closing remarks I have so far expressed my views on the steps to cope with a financial crisis. In closing, I will offer two thoughts with respect to financial crisis responses. First, it is necessary to make an objective assessment of what can be solved and what cannot be solved by policy responses to a financial crisis. Both in terms of macroeconomic policy and financial system measures, to take prompt and bold measures to address a financial crisis is not easy for any country, but is quite important. Without those measures, the economies will be forced to experience heavy adjustments and might end up in a perfect storm. At the same time, however, crisis responses do not eliminate the excesses accumulated in the periods preceding the crisis. When those excesses are really massive, it will take long for the economy to return to a sustainable growth path. Japan’s “lost decade” was partly attributable to such an element. If protectionism spreads triggered by intensified frustrations under such dire economic conditions, the economy’s potential growth rate itself might decline. In that regard, we also need to make a realistic assessment of the nature of the current crisis and limits of the crisis responses. Second, in a financial crisis, it is critical to ensure cooperation between the authorities – the deposit insurance corporation, the central bank, and financial supervisory authorities – which are responsible for financial system stability. Cooperation between each country’s authorities has also become increasingly important, reflecting the globalization of financial markets and hence the globalization of a financial crisis. Cooperative ties in terms of the nuts and bolts seem to have been furthered during the current crisis. At present, the cooperative relationship between jurisdictions appears to be strengthening at various levels. One element of the cooperative relationship is to share each country’s experience and lessons. In closing, I sincerely hope that the 4th Deposit Insurance Corporation of Japan Round Table in Tokyo would offer such a valuable opportunity to share each other’s recognition and exchange views between participants. Thank you very much.
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Excerpt from an address by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at a Meeting with Banks' Top Management, Tokyo, 24 March 2009.
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Masaaki Shirakawa: Provision of subordinated loans Excerpt from an address by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at a Meeting with Banks’ Top Management, Tokyo, 24 March 2009. * * * At the Policy Board meeting held on March 17, the Bank of Japan decided to explore a new framework for providing subordinated loans to banks. We have invited today representatives of banks which are subject to international capital standards to explain the background and the Bank of Japan’s view on the decision. The funding conditions for firms have deteriorated rapidly since last autumn due to the increased strains in global financial markets after the collapse of Lehman Brothers. While financial institutions have retained the financial intermediation function accordingly by increasing lending, the environment surrounding financial institutions has become increasingly severe due to the stock price plunge and the domestic economic downturn. Fund raising in financial markets for funds over the fiscal year-end has mostly been completed, but the firms continue to face difficult funding conditions. While the CP market has started to restore its function, funding in the capital market has been limited to the firms with high ratings. Looking ahead, while demand for funds to secure liquidity for the year-end and the fiscal year-end and demand for working capital due to the rise in raw material prices until last summer will decline, demand for funds to continue and to restructure business are expected to gain momentum. There might be a case in which the financial intermediation function will not be carried out smoothly from a macro perspective, if the strains in global financial markets increase and financial institutions become more conscious of possible capital constraints in the future. If financial institutions become more conscious of taking credit risk and all financial institutions take the same action simultaneously, the adverse feedback loop between the finance and the economy may intensify through financial institutions’ restraining from accumulating their assets, leading to the fallacy of composition, although the action is judged as rational for each individual institution. As a result, that might weaken the capital strength of each financial institution. From that point of view, concern is for the influence of a possible decline in stock prices. While the amount of stocks currently held by financial institutions is significantly reduced compared with the early 2000s, it remains unchanged that they hold substantial market risk associated with stockholdings. Although stock prices have recently somewhat rebounded, the financial systems in the U.S. and Europe have remained unstable. It should be avoided that each financial institution's consciousness about a possible decline in stock prices triggers the aforementioned fallacy of composition. Against such a backdrop, the Bank has decided to begin exploring specifically the provision of subordinated loans to the banks that are subject to international capital standards. This measure aims at ensuring the smooth functioning of financial intermediation and the stability of Japan’s financial system, by enabling Japan’s banks to maintain sufficient capital bases even in severe financial and economic environments. By the measure taken by the Bank, financial institutions are provided with three channels to raise capital; (1) capital raising by financial institutions through markets, (2) capital raising based on the Act on Special Measures for Strengthening Financial Functions, (3) borrowing subordinated loans from the Bank. Subordinated loans by the Bank will work effectively in conjunction with the other two measures to raise capital. In addition, providing such a safetynet measure would enhance the robustness of Japan’s financial system and the functioning of financial intermediation even under the stressed conditions. For a central bank, this kind of direct provision of quasi-capital funds is an extremely extraordinary measure. However, considering the future stress scenario of the financial system, the Bank has judged that, from the standpoint of a central bank, it is necessary to do its best to maintain the smooth functioning of financial intermediation and ensure the stability of the financial system even by conducting this extraordinary measure. The Bank expects financial institutions to grasp the thinking behind the measure and to strive to maintain the smooth functioning of financial intermediation with further efforts of boosting capital bases. Needless to say, risk management is extremely important for financial institutions, which cannot be emphasized too much. However, under the current circumstances, as I mentioned above, the surfacing of the risk stemming from the fallacy of composition should be avoided. To that end, it is important for the management of financial institutions, while conducting sound business operations, to boost capital bases with envisioning the consequences for Japan's economy. The Bank also expects financial institutions to pay due concern for the smooth communication with their client companies to convey business policies and lending stances. It is the basic premise that the stability of the financial system should be ensured in order to return to a sustainable economic growth path under price stability. From the standpoint of a central bank, the Bank is determined to make its best effort to secure the stability of the financial system. We would appreciate your continued support and cooperation. Thank you.
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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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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. * * * 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 – along with capital-raising by banks themselves in the markets and based on the Act on Special Measures for Strengthening Financial Functions – and ultimately to ensure the stability of the financial system. In view of this aim, the Bank will draw up a scheme for implementation as early as possible. As I have just explained, the Bank has been implementing various measures in rapid succession since the autumn of last year. The end of the fiscal year is only a few days away, but financial markets in Japan have so far remained relatively stable, as firms and financial institutions have strived to secure liquidity in a planned manner at an early stage and the Bank has provided large amounts of liquidity at a faster pace than in ordinary years. However, as I explained previously, Japan's economic and financial conditions will likely continue to be severe. In this situation, the Bank's policy priority will be placed, for the time being, on securing market stability and facilitating corporate financing – the second and third main areas of the Bank's conduct of monetary policy. In any event, the Bank will continue to examine carefully developments in financial markets and corporate financing and to take necessary measures in a decisive manner without any predetermined view. Closing remarks Today I explained economic and financial developments at home and abroad and the policy responses of the authorities around the world, including the Bank of Japan. As I said at the beginning of this speech, the current economic downturn is a process of correcting various imbalances that had accumulated over the past several years, and the severe situation will therefore likely continue for some time. I believe that Otaru has also been significantly affected by the global economic downturn, with a sharp drop in exports to Russia and a decrease in the number of domestic and foreign tourists. It is also true, however, that both domestic and overseas financial markets, especially money markets, have started to gradually regain stability. Furthermore, the effects of major countries' fiscal and monetary policies, as well as measures implemented to secure the stability of financial systems, are expected to be felt gradually. However, we must bear in mind the important fact that these policies and measures can only temporarily mitigate financial and economic shocks and reduce the degree of the economic downturn – in other words, they are merely measures to buy time. Resolution of various excesses in the private sector and the subsequent establishment of new business models are indispensable for realizing sustainable economic growth in the medium to long term. Fiscal and monetary policies are no more than a support to facilitate adjustments in and the positive efforts of the private sector. Japan's economy has been exposed to many severe downturns over the decades, but every time it enhanced its capability to create new products and services with added value based on the experience, strengthening the foundation for future growth. Good examples are the efforts made during the recession of the 1980s caused by the strong yen and in the 1990s after the bursting of the bubble economy. I hear reassuring remarks of corporate managers, for example, in the reports made at the meetings of general managers of the Bank's branches, such as that they are determined to continue with their investment in research and development, human resource training, and mergers and acquisitions, to prepare for the future despite, and also because of, the economic downturn. In addition, Japanese firms have continued to work assiduously in research and development of energy-saving and ecofriendly technologies, fields in which they are competitive, believing these fields to have growth potential. Otaru has a history of being a pioneering city, supporting the development of financial and economic activity in Hokkaido Prefecture. It has great potential, in that it is a city with a large number of tourist attractions and functions as a distribution center for the trade between Northeast Asia and the whole of Hokkaido Prefecture. I very much hope that you, as corporate managers, are determined to continue to develop creativity with which you can meet the current economic downturn as well as the severe competition, and that, when you have overcome the difficulties, Japan's economy, including Otaru, will transform itself into a more flexible, strong economy that can fully cope with global economic swings that may occur repeatedly in the future. The Bank will support firms' proactive activity from the financial side, and at the same time do its utmost as a central bank to realize the early return of Japan's economy to a sustainable growth path with price stability. Thank you very much for your kind attention.
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Statement by Mr Masaaki Shirakawa, Governor of the Bank of Japan, concerning the Bank's Semiannual Report on Currency and Monetary Control, before the Committee on Financial Affairs, House of Representatives, Tokyo, 13 March 2009.
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Masaaki Shirakawa: Recent developments in Japan’s economy and the conduct of monetary policy Statement by Mr Masaaki Shirakawa, Governor of the Bank of Japan, concerning the Bank's Semiannual Report on Currency and Monetary Control, before the Committee on Financial Affairs, House of Representatives, Tokyo, 13 March 2009. * * * Introduction I am pleased to have this opportunity to present an overall review of the Bank of Japan's conduct of monetary policy. The Bank submitted to the Diet its Semiannual Report on Currency and Monetary Control for the second half of fiscal 2007 on June 10, 2008 and that for the first half of fiscal 2008 on December 12, 2008. Today I would like to talk about recent developments in Japan's economy and the conduct of monetary policy. I. Developments in Japan's economy Japan's exports have been decreasing substantially reflecting a slowdown in overseas economies, and domestic demand has become weaker against the background of declining corporate profits and the worsening employment and income situation in the household sector. Financial conditions have remained tight, as shown by, for example, a continued increase in the number of firms, especially small firms, reporting that their financial positions are weak and lending attitudes of financial institutions are severe. Under these circumstances, economic conditions have deteriorated significantly and are likely to continue deteriorating for the time being. On the price front, domestic corporate goods prices have been decreasing, mainly due to the drop in international commodity prices. The year-on-year rate of increase in the CPI (excluding fresh food) has recently moderated reflecting the declines in the prices of petroleum products and the stabilization of food prices, and, with increasing slackness evident in supply and demand conditions, will likely become negative in the future. There are risks to the outlook for economic activity and prices. Much depends on global financial conditions as well as developments in overseas economies, and particular attention will need to be paid to the downside risks to economic activity. In addition, there is the risk of a further weakening in domestic private demand if firms' medium- to long-term growth expectations decline and pressures to adjust capital stock and employment increase. If financial conditions should tighten further, pressures acting to depress economic activity from the financial side might become more marked and the adverse feedback loop between financial and economic activity might intensify. Turning to prices, there is a possibility that the inflation rate will decline further if downside risks to economic activity materialize or commodity prices fall. In this case, the risk of a decline in the medium- to long-term inflation expectations of firms and households would warrant attention. II. Conduct of monetary policy Since fall 2008, when the turmoil in global financial markets and in the U.S. and European financial systems increased in severity, the Bank, in order to support the economy from the financial side, has taken monetary easing measures in the following three areas: reductions in the policy interest rate, provision of ample liquidity to stabilize financial markets, and facilitation of corporate financing. Regarding the policy interest rate, the Bank reduced it twice in October and December 2008, and currently encourages the uncollateralized overnight call rate to remain at around 0.1 percent. In order to ensure stability in financial markets, the Bank, as part of the coordinated measures of central banks, has been conducting U.S. dollar funds-supplying operations whereby funds are provided with no explicit ceiling on the total amount. The Bank has also continued to provide ample liquidity in yen, taking measures such as actively purchasing Japanese government securities under repurchase agreements and increasing the amount of outright purchases of Japanese government bonds (JGBs). To facilitate corporate financing, the Bank has expanded the range of corporate financing instruments eligible as collateral, and has conducted special funds-supplying operations to facilitate corporate financing through which, taking corporate debt as collateral, it provides unlimited funds at a low interest rate. The Bank has also implemented measures exceptional for a central bank, such as outright purchases of CP and corporate bonds. Meanwhile, the Bank resumed purchases of stocks held by financial institutions in February 2009, to support financial institutions' future endeavors to reduce market risk associated with stockholdings and thereby ensure the stability of the financial system. III. The future conduct of monetary policy The outlook for economic activity and prices is highly uncertain at present. The Bank will continue to carefully assess the future outlook for economic activity and prices, closely considering the likelihood of its projections as well as risk factors, and to exert its utmost efforts as a central bank to facilitate the return of Japan's economy to a sustainable growth path with price stability.
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Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at Japan Society, New York, 23 April 2009.
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Masaaki Shirakawa: Way out of economic and financial crisis – lessons and policy actions Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at Japan Society, New York, 23 April 2009. * * * Introduction Good afternoon, ladies and gentlemen. First of all, I would like to thank both Japan Society and the Institute of International Bankers for giving me the opportunity to appear before such distinguished guests. I also appreciate the warm introduction by Mr. Rhodes. The global economy is suffering through the crisis of an exceptional scale. Many countries are struggling with the consequences of the global credit excess accumulated in the period of what we used to call “Great Moderation”. How to extricate our economies out of this plight is a top priority for governments and central banks all over the world. In these unusual circumstances, Japan’s crisis episode almost a decade ago is drawing renewed attention. Japan went through a boom-and-bust cycle from the late 1980s to the beginning of this century. Throughout the 1990s, Japan’s economy was caught in a prolonged stagnation. Japan also experienced a systemic financial crisis. Because of these, Japan’s 1990s is often referred to as the “lost decade”. A “lost decade” is a memorable and captivating phrase, although not to my liking for the reasons I will discuss later. In fact, the background of Japan’s economic slump during the 1990s was intensely debated in and outside Japan. In those discussions, Japan’s “lost decade” was often considered as uniquely Japanese. But when it comes to falling economic activity and a weakening financial system, there are amazing similarities between Japan’s experience in the 1990s and what the US has been through since the summer of 2007. And this leads some to argue that the US might be entering its own version of the “lost…not necessarily decade but something else”. With these in mind, I would like to structure my discussion into three parts. In the first part, I will talk about the similarities between Japan’s previous crisis and the present US difficulties. However, it is not my intention to lecture you on what the US should do at this juncture. This is because no two crises are identical and because Japan itself is also mired in a severe economic downturn now. In the second part, I would like to revisit Japan’s crisis experience from a broader perspective so that we can draw lessons in a multi-dimensional manner. In the final part, l will focus on the actions policymakers need to take in order to resolve the current crisis. To the extent relevant, I will touch on some aspects of crisis prevention as well. Learning the past crisis lessons To begin with, allow me to strike a personal note for a second. Back in May of 1990, the Bank of Japan created a new department responsible for financial stability and I was chosen as a division chief. Then Governor Mieno gave my boss and myself a mandate to spell out policy prescriptions so that the Bank of Japan can prepare itself for possible failures of financial institutions. At that time, Japan’s economy was still in the booming mood. Although the stock market had peaked out already, property valuations still continued to rise. Looking back, I cannot help but think that the Governor was very prescient because it was a few years later that the initial signs of financial instability came to the surface. To fulfill the fresh mandate given by the Governor, my boss and I went on a two-week tour to the US and Europe to learn how foreign central banks and supervisory authorities handled the past financial crises in their jurisdictions. Here in the US, we met a lot of experts at the Federal Reserve Board, Federal Reserve Bank of New York, Federal Deposit Insurance Corporation (FDIC) and Resolution Trust Corporation (RTC), all of whom were generous enough to share their experiences and insights with us. We discussed the failure of Continental Illinois National Bank, the savings and loan crisis, and the demise of Drexel Burnham Lambert among others. On that basis, the Bank of Japan was able to develop in the early 1990s its own policy framework for possible financial contingencies in Japan. This framework evolved gradually to contain four pillars by the mid-1990s. First, when banks are found to be capital-deficient, the authorities should encourage them to carry out restructuring and raise additional capital from private investors. Second, when dealing with an insolvent bank, the authorities should explore a full range of measures, including assumptions by a stronger bank with financial assistance through the deposit insurance scheme, establishment of an asset management company to separate bad assets, and creation of a bridge institution to preserve the function of the failed bank. Third, a central bank should act as a lender of last resort when banks are facing liquidity pressures with systemic implications. Fourth, when banks find it difficult to raise capital in the market, the authorities should consider the possibility of injecting public funds. Such recapitalization with the state budget should come with a commitment by the management of the recipient bank to take due responsibilities and its existing shareholders to incur possible losses. I believe these generic principles still hold true in today’s environment. But in hindsight, I have to admit that they are only part of more comprehensive strategies for dealing with a fullblown financial crisis like the one we are witnessing. We need to ask ourselves why such comprehensive policies were not implemented in a timely manner. Financial crises: similarities between Japan and the US With these things in mind, I would next like to point out remarkable similarities between Japan’s crisis experience from the 1990s to early this century and what the US has undergone in the past several years. These commonalities fall into five categories. First, financial crises in both countries were preceded by high economic growth and low inflation for an extended period of time. Japan’s economic ascent in the 1980s looked unstoppable. The continued strength in the US economy in the last decade was emblematic of the so-called Great Moderation. In Japan’s case, people strengthened confidence in the late 1980s after riding out the Oil Crises. Japan became the world largest creditor country by then with an increasing presence in the global economy. A sharp and sustained rise in land prices in those days was seen as a vindication of Japan’s stronger economic fundamentals. At the end of 1989, Japan’s stock market capitalization accounted for nearly half the world’s total and the land values of the Tokyo metropolitan area alone were said to equal those of the entire US. What an irrational frenzy it was. Second, both Japan and the US took time to recognize the collapse of the economic bubbles and to appreciate its substantive implications for the broader economy. In fact, Japan’s equity prices peaked at the end of 1989 and the nation-wide land price index in September 1991. It was in July 1991 that the Bank of Japan started the easing cycle in its interest rate policy. Even at that time, though, many people cautioned that lower interest rates could lead to a resurgence of asset bubbles. In the US, residential investment growth turned negative in the first quarter of 2006 and the house prices peaked in May 2006. But it was in September 2007 that the Federal Reserve began to slash policy rates. Some attributed the irrational rise in international commodity prices then to the rate cuts by the Federal Reserve. In the early stage of the bubble bursting, it took us quite a while to understand how serious its negative impact on the economy would be. We optimistically thought Japan’s economy would pick up once cyclical corrections in business investment had run their course. This initial optimism was proved wrong by the subsequent deterioration in the downward spiral between the financial system and the real economy. The US is no exception in this regard. Policymakers often say “bubbles cannot be detected until they burst”. But more accurately, we should say “bubbles cannot be readily identified even after they burst”. The difficulty of identifying economic bubbles, both ex ante and ex post, has important implications for monetary policy. So I will come back to this topic later. Third, liquidity strains have been a prime catalyst for many of the past financial crises. In Japan’s case, the failure of a mid-sized securities house to honor its inter-bank obligations triggered severe dislocations in the money market, which spread instantaneously to the wider segment of Japan’s financial markets. Similarly, the collapse of Lehman Brothers in September 2008 caused acute liquidity seizure, thereby shattering the confidence chain in the global financial markets and clogging credit flows between lenders and borrowers. Fourth, even when financial stability was in jeopardy, decisive measures such as public capital injections did not come until the market disruptions reached a critical point in our two countries. Several reasons explain this. Even in countries like Japan where banks’ executive compensations are relatively modest, financial institutions are not necessarily popular. Moreover, ordinary citizens do not appreciate the importance of credit intermediation until they lose it. For these reasons, we tend to be slow in taking decisive steps. Even if we agree on the need to use taxpayers’ money to stabilize the financial system, policy actions tend to be piecemeal in the face of public outrage over the mismanaged financial firms. In Japan’s case, the authorities decided in the mid-1990s to provide a financial support to small credit cooperatives and specialized mortgage lenders. But the reckless lending by some of these entities sparked public anger and the financial support with taxpayers’ money was hotly contested in the Diet. This is part of the reason why recapitalization of systemically important banks was delayed to the late 1990s in Japan. Such policy procrastination continued in spite of the voluntary curbs on banks’ executive pay and therefore worsened the spiral between the economic contraction and the banking sector problems, making the disposals of bad assets even more difficult. As late as in 1999, the Japanese government finally infused sizable amount of capital into major banks. But even this turned out to be insufficient to revitalize Japan’s banking industry. Fifth, there are similarities on monetary policy front. During the crisis, the Bank of Japan provided ample liquidity and brought the policy rate down to zero. In so doing, the Bank of Japan extended the maturities of liquidity-providing operations while expanding the range of acceptable collateral and counterparties. We also introduced a special lending facility to ease funding stress in the markets. Furthermore, we purchased private-label securities such as asset-backed commercial paper (ABCP) and asset-backed securities (ABS). In this crisis, the US authorities have implemented a variety of measures similar to those innovative steps the Bank of Japan took in the past. I will take up this point later. What was Japan’s “lost decade”? As I mentioned at the outset, Japan’s 1990s is described as a “lost decade”. This catchy phrase has a straightforward implication that Japan’s economy was plagued by a long stagnation. But I do not like this characterization because it is too simplistic, misguiding us in terms of the way we address the problems and thereby formulate appropriate policy responses. So I would like to do some reality check again for a more balanced assessment of Japan’s experience in the 1990s. First, it is true that Japan’s economy was lackluster throughout the 1990s. In that period, Japan’s average yearly growth rate was only 1.3% in real terms, much less than the preceding decade’s average of 4.0%. However, even in 1998, the worst year in the postbubble period, Japan’s growth rate was minus 1.5%, apparently less dismal than the sharp slowdown we are facing now. Also, even during the financial crisis, Japan’s real GDP did not fall below the level registered at the peak of the bubble days (1989). I think this owed much to the authorities’ efforts to avert financial meltdown by using all means available, including the extension of blanket guarantees for all forms of bank liabilities. Second, even in the low-growth 1990s, there were some tentative recoveries in Japan’s economy, which led people to hastily believe that the economy has finally regained traction. They turned out to be false dawns, but it is human nature to become optimistic when things improve a little. Third, Japan’s crisis episode tends to be discussed in the context of deflation. To be more precise, however, what worried us most in those days was asset deflation, rather than price deflation as we usually presume by the terminology “deflation”. In fact, the peak-to-bottom declines in real estate valuations of large cities in Japan were in the order of minus 70-80%, while the cumulative fall in CPI between 1997 and 2004 was minus 3%. The real difficulties Japan confronted were the dangerous interactions between asset deflation and the banking sector fragility. Fourth, we should also note that, following the crash of the bubbles, Japan’s trend growth stagnated for a sustained period of time and there are structural dimensions to that. From the late 1980s through 1990s, Japan did not adapt successfully to the profound changes in the global economy; namely, a wave of deregulation, globalization and revolution of information and communication technology. These tidal waves prompted a deeper integration of global markets, supported by the division of production processes on a global scale. In this new landscape, foreign companies optimally deployed their production sites and distribution channels to create value added, making greater use of outsourcing for cost efficiency. But this posed a challenge to Japanese firms whose comparative advantage was in a centrally-controlled and team-oriented production chain. This Japanese industrial model was supported by high-skilled domestic workers who were under the umbrella of life-time employment. Preoccupied with the past success of their business models, however, Japanese companies were slow in responding to the changing realities in the global economy. Japan’s economic bubbles added to the sense of complacency, too. Coupled with the weakening credit intermediation owing to the non-performing asset problem, such inability to change undermined an efficient allocation of resources and reduced Japan’s growth potential. Lower trend growth, in turn, protracted Japan’s economic ailment after the bubbles burst. Together with the excesses left by the bubbles which I will explain later, this is one of the fundamental reasons why Japan’s economy remained sluggish in the 1990s. Lessons from Japan’s “lost decade” Next, let me talk about what kind of lessons we should take from Japan’s so-called lost decade. The term “lost decade” has a connotation that rapid and bold actions by the authorities could have resolved the crisis much sooner. I do not deny the importance of aggressive policy responses in exigent circumstances. However, as a central banker who muddled through the tough times following the asset bubble crash, I suspect the simplification of this sort fails to capture the totality and subtlety of the problems Japan encountered in the 1990s, or for that matter, any economic crises of a comparable magnitude. In order to understand why Japan took a decade to put the economy back on a sustainable growth trajectory, we need to review Japan’s experience from a broader policy perspective. I would like to emphasize three points in particular. First, it is not always the case that “bold actions” are judged to be bold afterwards. As I said, the Japanese government embarked on large capital injections in 1999 but this was not enough to limit the vicious spiral between the economic deterioration and the financial crisis. After all, this is what the adverse feedback loop is all about. Second, as I already mentioned in regard to the banking crisis in Japan, bold and rapid policy actions for securing financial stability tend to be politically unpopular. Therefore, policymakers should convince the public that crisis management operations by governments and central banks are not intended to rescue the failing banks but to save the entire financial system. Third, macroeconomic policies are no panacea although they play a key role in combating a sharp slowdown in the economy. We cannot regain strong economic growth unless we clean up the excesses created in the bubble period. Likewise, macroeconomic policies cannot deal with the productivity losses arising from the inability of companies to adjust their business models. As these points are essential, allow me to spend a few more words. Japan’s economic imbalances accumulated in the exuberant times were enormous. In the booming 1980s, Japanese businesses increased borrowings substantially and their investment surged at a double-digit pace in the three years to 1990. Once the bubble began to collapse in the early 1990s, resource utilization declined sharply and non-performing assets started to rise. In short, Japan piled up excesses in debt, capacity and labor. As you can see, imbalances of this size take a long time to unwind. Japan’s economy recovered on the back of the stabilization of the financial system. But equally crucial for Japan’s economic revival was the elimination of those excesses. After shedding excesses, Japanese companies began to integrate themselves into the global value chain. This transformation was particularly visible for manufacturing industries such as electronics, automobiles and general machineries. In other words, following the structural shake-out in the late 1990s, Japanese companies re-invented themselves to be able to reap the benefits of global economic dynamism that involved both advanced and emerging economies. Policy actions for crisis resolution So far I was speaking in a past tense, talking mainly about Japan’s crisis experience in the 1990s and early this century. In the remaining time, I would like to discuss policy actions needed in the current environment. I already mentioned the striking similarities between Japan’s economic difficulties in the 1990s and the current US economic crisis. But we should not forget about the differences, either. For example, unlike Japan where banks play a larger role in credit allocation, the US relies more heavily on capital markets for financial intermediation. In addition, while Japan’s non-performing assets were mostly concentrated in commercial real estate loans, the US problem originated in the securitization market. In theory, losses on securitized assets are easier to crystallize than those on commercial real estate loans because securitized assets are constantly re-priced in the market. However, fair values of securitized assets become much harder to determine when their market liquidity is impaired. Dispersion of securitized assets throughout the investor universe creates additional complexity, too. Since the onset of the current crisis, policymakers around the world have been treading very carefully between the two requirements: facilitating financial de-leveraging on the one hand, while preventing a sharp contraction in economic activity on the other. This is a fine balancing act because de-leveraging and economic downturns can be trapped in an adverse feedback loop. Policies I would suggest to combat the crisis of this sort are based on four pillars. They have already been adopted in our two countries, but let me repeat them. First, we need to make sure that the liquidity needs in financial markets are smoothly met. This is indispensable for financial stability. As I said before, most of the past financial crises started from a sharp pullback in funding liquidity. Liquidity concerns are highly contagious and capable of eroding the foundations on which our financial system is built. In the present crisis, therefore, a number of central banks have substantially expanded their liquidity operations in domestic currencies. To alleviate dollar funding pressures, major central banks have also activated temporary swap lines with the US Federal Reserve to provide dollars to financial institutions in their national markets. Second, when credit markets are under severe stress, a central bank is sometimes expected to step in to support market functioning. The modality for central bank intervention differs across individual circumstances. For instance, the Federal Reserve has pursued credit easing policy to unfreeze the US financial market by purchasing plain as well as assetbacked commercial paper, agency-related securities and so forth. In spite of its bankcentered system, Japan has also been affected by the turmoil in global capital markets. In fact, Japan’s commercial paper and corporate bond markets tightened sharply in the last several months, which caused an acute squeeze in Japan’s corporate finance. To counter this, the Bank of Japan has started buying commercial paper and shorter-term corporate bonds, assuming credit risk of private sector debtors. Overall, Japanese banks are in stable conditions and we do not see a systemic problem in them. However, Japanese banks have sizable holdings of corporate shares and part of the unrealized gains on those share-holdings constitutes banks’ Tier II capital. Therefore, falling equity prices reduce their capital buffers and constrain the financial intermediation process. To alleviate this, the Bank of Japan has restarted the purchase of bank-held corporate shares. In a similar vein, the Bank of Japan has also announced a plan to supply subordinated loans to the Japanese banks subject to international capital standards. This is aimed at bolstering their Tier II capital. I would like to emphasize that these measures are quite exceptional by central banks’ standards. In a nutshell, the US and Japan are working in their own ways to relieve the tensions in the credit markets. Third, when the vicious circle between the economic downturn and financial instability is in motion, macroeconomic policies should play an active part in boosting aggregate demand. Interest rate reductions are most traditional in the policy tool-kit and both the Federal Reserve and the Bank of Japan have cut their policy rates to effectively zero. Fiscal stimulus should be considered as well, without putting the long-term fiscal discipline at risk. As highlighted in the recent G20 summit communiqué, major countries are already undertaking a fiscal expansion that will amount to $5 trillion by the end of next year. Fourth, a holistic approach is needed to restore financial stability. By “holistic”, I mean implementing a range of policy measures in tandem, including capital augmentation for banks and the removal of problem assets from their balance sheets. Financial system is built on the trust between lenders and borrowers. Once this foundation is shaken, it takes time to resume a normal functioning of the financial system. Currently, the global financial system is still afflicted by a loss of confidence. In order to allay widespread fears over financial instability, the authorities around the world have taken numerous steps such as capital injections, public guarantees for banks’ debts, separation of toxic exposures and the like. Separating impaired assets from banks while reinforcing their capital bases is a critical but the most difficult part of the financial rehabilitation strategy. In the first place, it is far from easy to grasp the extent of banks’ capital shortfalls. Securitized assets have a complex risk profile due to their multi-tranche structure. Worse still, market liquidity for these complex assets has evaporated for the past year or so, further complicating their fair value measurement. The negative interactions between the economic downturn and financial instability are generating fresh losses, thereby aggravating concerns over banks’ capital shortages. Any attempt at breaking into this sinister feedback loop is as tricky as chasing after a moving target. On top of that, it is politically hard to reach a consensus on the sufficiency of government capital infusions. This is why public capital injections tend to be insufficient and behind the curve. But there is no quick fix. While making the best efforts to capture the extent of banks’ asset degradation, policymakers should communicate the importance of financial stability to taxpayers so that they become more receptive to the needed policy steps, however unpopular they might be. To sum up, I spoke about four key elements of financial crisis management: 1) ample liquidity provisions, 2) support for credit market functioning, 3) macroeconomic stimulus, and 4) injections of public capital and elimination of balance sheet uncertainties. Without effective policy measures on these fronts, the economy will deteriorate much faster and deeper. But we need to be aware that policymakers are not omnipotent. The policy actions we have taken in the past twenty months are no substitute for the necessary unwinding of economic imbalances accumulated in the preceding booms. As I mentioned earlier, Japan’s economy did not resume sustainable recovery until it eliminated excess debt, excess capacity and excess labor. The same goes for the current crisis. I think the US economy needs to work out excesses, which include unsustainable financial leverage, household over-indebtedness, and perhaps the over-extension of the financial industry. This will be painful but inescapable. In view of Japan’s decade-long experience, there are no palatable alternatives. One more note of caution. Because of the pain associated with the unwinding of excesses, we might be leaning toward protectionist measures in trade and finance. But we must resist a descent into protectionism by any means. Like protectionism, regulatory overreaction will also undermine the economic efficiency, thereby putting downward pressure on productivity growth. Without question, this is the last thing we intend to achieve. Challenges ahead: crisis prevention What I have so far said concerns crisis resolution. But crisis prevention is equally important from the longer-term viewpoint. Let me sketch this out. First of all, the current crisis presents a challenge for the conduct of monetary policy. It requires a change not only in policymakers’ way of thinking but also in the theoretical underpinnings on which actual policies have been formulated. In the last two decades, macroeconomics as a professional discipline has evolved with impressive sophistication. If I may put it simply, its implications for policy practitioners might be condensed into three points. First, economic growth potential is maximized under the sustained stability in prices. Second, central banks’ monetary policy should be aimed primarily at achieving price stability. Third, as a corollary of the first and the second, the onus for macroeconomic stabilization should be mainly on monetary policy. Of course, there is nothing wrong with each of these propositions. But over time, they seem to have created a sense of complacency among us with regard to the potency of monetary policy. For instance, some macroeconomic theorists have claimed that a depression is no longer a real concern. However, the current crisis, including its run-up, demonstrates that a macroeconomic theory does not take proper account of the dynamics in financial systems and the irrational behavior of human being such as herding and indulgence in excessive optimism. Therefore, from a preventive vantage point, we need to develop a broader approach. Under benign economic conditions, imbalances could accumulate through a number of channels. As we saw in Japan in the 1980s and in the US in the early 2000s, expectations of sustained low interest rates often contribute to the build-up of economic excesses through higher leverage. In good times, financial institutions also tend to extrapolate low historical volatilities into their measurement of potential risk exposures. Intense competition puts additional pressure on those institutions to take on risks beyond their capacity. Such strong inclinations for risk-taking at the level of individual financial institutions can lead to excessive risk-taking at the aggregate level, thereby sustaining asset price hikes and making the entire financial system more vulnerable to sharp reversals of risk positions and the resulting squeeze in market liquidity. Given these all, I think it is becoming increasingly important for policymakers to sharpen macro-prudential perspectives, by which I mean two things in particular. One is to keep monitoring risk distributions throughout the whole financial system. The other is to analyze how the financial system evolves within itself as well as through the complex interaction with the real economy. These perspectives are vital not only for regulatory and supervisory purposes alone but also for the conduct of monetary policy. In fact, there are a number of specific issues we need to examine in a macro-prudential framework. Because of the time constraints, however, I will just touch upon the most important aspect for central bankers. Namely, how macro-prudential perspectives relate to monetary policy. How to deal with economic bubbles has been a controversial topic. One school of thought has argued that a central bank should pursue aggressive monetary easing after the bubble bursts. This line of thinking is based on a belief that bubbles are difficult to spot beforehand and central banks can merely mop up the debris of the collapsed bubbles. But I beg to differ. Quite often, bubbles are too elusive to identify even when they are crashing. On top of that, when accumulated excesses are being unwound in the aftermath of the bubble bursting, the efficacy of central bank’s easing policy is materially reduced as we are witnessing now. So what should we do? First and foremost, central banks should be attentive to both the prevention of bubbles and the mitigation of their consequences. I believe this symmetrical approach is important. Central banks should remain vigilant as to whether excesses are lurking in the economy. As economic imbalances pile up insidiously, a narrow focus on price stability makes it more likely for policymakers to overlook dangerous signs emerging in the wider economy. This is exactly where macro-prudential perspectives come in. Financial imbalances typically manifest themselves in sharp credit expansion, outsized leverage, soaring asset prices, or combination of those. These are the parameters central banks should watch carefully. But excesses can appear in other forms, too. The challenge for central banks is that economic imbalances have a long “formative period” so to speak, spanning much longer than the normal time horizon of monetary policy implementation. Therefore, if we focus narrowly on short-term movements in consumer price inflation, this could have an unintended consequence of fostering the creation of bubbles. In response to the bursting of the information technology bubble early this century and the deflation scare associated with that, monetary policy was eased on a global scale and for an extended period of time. Unfortunately this has proved to be one of the contributing factors to the global credit bubbles and the resulting mess in the global financial system. Central banks should not be hesitant in pursuing aggressive monetary easing when economic conditions warrant. In a severe economic crisis, policymakers have to be careful not to mistake a temporary rebound in the economy, or a false dawn I would say, for a genuine recovery. But there is no economic crisis that never ends. So central banks should also be mindful of a timely exit from those aggressive easing measures. A late exit can be an entry into something worse. Finally, let me add that monetary policy alone cannot prevent the recurrence of boom-andbust oscillations. For example, a host of issues remain to be addressed in the regulatory and supervisory arena as well. Closing remark Since I am almost 40 minutes into my speech, I would like to finish with a final message. What we are confronting is not a garden-variety recession. This is the crisis of a truly global nature. In the early 2000s, Japan was able to benefit from the recovery in the global economy. This time, we cannot count on others in getting out of the woods. But over the past year or so, we have together achieved a lot in our fight against the crisis. In that spirit, we will continue to work out both individual and shared solutions. Let us move ahead together to rebuild sustainable and efficient financial systems for us and for our future generations. Thank you very much for your listening.
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Remarks by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at the Panel Session at the 45th Annual Conf. on Bank Structure & Competition, sponsored by the Fed. Res. Bank of Chicago, Chicago, 8 May 2009.
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Kiyohiko G Nishimura: “The past does not repeat itself, but it rhymes” – four lessons learned from the financial crises Remarks by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at the Panel Session "Responding to the Financial Crises: Lessons Learned" at the 45th Annual Conference on Bank Structure and Competition, sponsored by the Federal Reserve Bank of Chicago, Chicago, 8 May 2009. * * * Thank you, Chairman. It is always pleasant to come to Chicago, even when the topic of the discussion is challenging, and I am grateful to the Chicago Fed for inviting me to this esteemed conference. Needless to say, we have already learned many hard lessons from the current crisis. For the sake of better financial regulation, I would like to focus on four lessons in particular. 1. Lesson One The first lesson is encapsulated in Mark Twain’s famous line, “The past does not repeat itself, but it rhymes”. It is now fair to say that many thought Japan’s so-called “lost decade” was a problem peculiar to Japan, and also, by learning well from that problem, it was not going to be repeated elsewhere. Unfortunately, this has turned out not to be the case. In fact, we can see a remarkable resemblance in the development of the financial crises and subsequent policy responses between the current US situation and Japan’s lost decade. Chart 1 shows a rough mapping of events in the time line between the current US crisis and Japan’s lost decade. In both countries, the problem had its root cause in the property markets. In the US, the legacy or toxic assets were sub-prime RMBS and their related securitized products; in Japan, they were commercial properties in central business districts, particularly in Tokyo. It was these toxic assets that gradually began to hurt banks’ balance sheets. We then saw an adverse feedback loop develop between financial distress and economic activity. The subsequent policy responses by both Japan and the US also bear a marked resemblance. However, the past does not repeat itself exactly, as the “time scale” and the degree of “acceleration” in the two crises were different. In the early stages, one month in the development of the US crisis seemed to be equivalent to three months in the development of Japan’s, but the pace later accelerated, and it now appears that one US month is equal to five or six months in Japan of the 1990s. What made the difference to the time scale and acceleration? Innovations and structural changes over the last two decades have no doubt played an important role, namely globalization, advances in information communication technology, and financial innovations and sophistication. Indeed, compared with Japan in the 1990s, the current crisis is far more complex, interconnected and global. Accordingly, the velocity of market dysfunction has been much faster and its contagion much more widespread than in Japan’s case, and the damage inflicted on the global financial system and economy has been far more devastating than Japan’s non-performing loan problem. 2. Lesson Two The second lesson we have learned from the crises is that once an adverse feedback loop has been started, it is extremely difficult and costly to stop it and to restore confidence. This was the essence of Japan’s experience; a series of fiscal stimulus packages and an accommodative monetary policy could not generate sustained economic growth, as the financial system was severely impaired and market confidence continued to be eroded. Injections of public capital in 1998 and 1999 were also, in retrospect, not sufficient to convince the market to jump-start the economy. This is evident in Chart 2. At the same time, it was clear that the Japanese economy was suffering from a significant productivity slowdown from its peak in the 1980s. So when and how did Japan’s adverse feedback loop stop? With hindsight, perhaps the turning point was October 2002, when the Financial Services Agency urged major banks to halve their NPL ratios by the end of March 2005, and pledged to monitor their efforts continuously and rigorously. The Bank of Japan also urged banks to carry out more rigorous evaluations of NPLs, and to dispose of them promptly based on those evaluations. In retrospect, the timing coincided with the reflection point at which the economy had just passed the trough of the 2001 recession, and began to recover, thanks to strong export demand due to the vigorous world economy. This was also the time when substantial progress was being made in corporate restructuring with respect to the so-called “three excesses”: debt, employment and production capacity. This restructuring helped the final pick up. In this way, the Japanese economy was, in general, out of the woods around 2005, although some regional economies lagged behind, having benefited less from the global growth. 3. Lesson Three I will move on to the third lesson and ask the following question: “Is it possible to solve problems with troubled assets at an early stage?” I find the answer is unfortunately negative: “It is very difficult”. This is because when the valuation of troubled assets becomes highly uncertain, in the way Frank Knight described here in Chicago eighty-some years ago, a “wait and see” strategy may be the natural reaction for both sellers and buyers 1 . So, private initiatives alone may not be sufficient to solve the problem. We have a list of such private attempts, with the fate of the M-LEC among them, as well as the Cooperative Credit Purchase Corporation in Japan in 1993. At the same time, it becomes increasingly difficult and costly for financial institutions with troubled assets to raise capital once the market becomes suspicious. However, governments usually face severe difficulty gaining public support for intervention in the early stages of a crisis, as we have seen recently, while the financial institutions themselves seek to avoid stigma and government interference. 4. Lesson Four What is the core of the problem? Lesson Four of the crises is that it is the difficulty in getting “reasonable estimates” of losses and a “reasonable pricing” of troubled assets, on which both See Nishimura, K. G., and H. Ozaki, “Irreversible investment and Knightian uncertainty” Journal of Economic Theory 136 (2007), pp668-694. sellers and buyers can agree, that leads to erosion in confidence. It is this erosion in confidence which then leads to an “excessive” aversion to uncertainty. There are a number of related factors which have contributed to the current erosion in confidence. Firstly, troubled assets have had macro-systemic effects, including unprecedented levels of downside-correlation. Secondly, these troubled assets’ losses were dynamic and evolved over time. The “estimated losses” increased continuously as the economy slid into stagnation. Valuation of these assets, based on pre-crisis norms, grossly and consistently underestimated the losses, leading to an erosion of confidence in valuation methods and ultimately in the solvency of the institutions with these assets. Moreover, troubled assets were very heterogeneous, and the erosion of confidence in existing valuation methods set an adverse selection mechanism in motion, leading to a marked deterioration in market liquidity. Let me briefly summarize the implications of erosion (or contamination) of investors’ confidence in financial institutions. Once they lose confidence, these investors face “unknown unknowns” that they never dreamed of before. They then become “excessively” averse to uncertainty surrounding the future prospects of financial institutions. That is, they make decisions based on the “worst possible case scenario” and try to minimize the losses they would incur in this worst possible case 2 . Their valuation of these financial institutions thereby turns out to be “excessively” pessimistic, and they become very sensitive to any news that supposedly has some bearing on the worst possible case scenario. Moreover, they tend to “wait and see,” until they feel more confident about the valuation of troubled assets. The result of these factors and their erosion of confidence is a significant undervaluation of financial institutions at the trough of an economic downturn. 5. Concluding remarks: so what should we do? Having seen the devastating effects of the adverse feedback loop and erosion of confidence, the natural reaction or desire would be to make every effort to avoid macro-systemic financial distress, and thus to regulate macro-systemically important financial institutions more closely and comprehensively, as was agreed at the G20 London summit, in order to prevent another crisis from developing. However, at the same time, it is also important to bear in mind the following three points: Firstly, we should avoid any “pro-cyclicality” of reforming zeal, such as strengthening regulations in the downturn when it may further exacerbate the slump, or deregulating the industry in the upturn when vigilance is called for. Past experience, as exemplified in Lesson One, suggests we are very much prone to this tendency. Secondly, we should also bear in mind that no regulation is perfect. The origins of financial crises often lie in financial institutions’ regulatory arbitrages and investors’ complacent behavior based on “plausible deniability”. Also, we live in a dynamic world and are always subject to innovations and structural changes so that, as we have just learned, it is virtually impossible to identify and eliminate in advance all possible causes of financial distress. Thus, thirdly, we should prepare for the conceivably worst case in “normal” times, when confidence is still maintained. Lessons Three and Four show the fundamental problem of the financial crises is the difficulty in raising capital when it is most needed, because of the adverse feedback loop and erosion of confidence. It is worth exploring the feasibility of See Nishimura, K. G., and H. Ozaki, “An axiomatic approach to ε-contamination” Economic Theory 27 (2006), pp333-340. macroeconomic pre-committed or pre-paid “safety-net” schemes to complement ex-ante regulations. In this regard, contingent capital schemes and their variants are particularly worth exploring when designing regulatory reforms for macro-systemically important financial institutions. Several such schemes have been proposed within the framework of private initiatives: capital insurance by Kashyap, Rajan, and Stein; reverse convertible debenture by the Squam Lake Working Group; and “margin calls” on shareholders by Hart and Zingales. For example, in the capital insurance scheme, participating institutions pay “systemic-risk insurance” premiums to insurers in good times, and get capital from them in bad times when a systemic risk materializes. Since what we are preparing for is macro-systemic risk, the trigger should be a macroeconomic event. Other proposed schemes also rely on private incentives to supply capital to financial institutions when they need it. However, private initiatives are not likely to be sufficient to cope with financial institutions’ capital shortages in macro-systemic events, since insurers may find themselves in distress and unable to provide the necessary capital 3 . Moreover, a large-scale systemic risk is very rare, and its probability is very hard to measure, if not impossible. Insurers would demand much higher premiums than usual to take on such almost totally unknown risk (“uncertainty” in the spirit of Frank Knight, as mentioned before). In that case, it may be reasonable to have a public-private partnership capital insurance scheme in which private insurers insure the risk up to a certain point and a government takes the rest (up to a pre-specified limit). This is in fact quite similar to earthquake insurance in Japan. These schemes, however, have their own problems. When insured, an institution may find it attractive to take further risk. We need appropriate supervision to prevent this moral hazard behavior. A non-participating institution may benefit from financial stability without paying its fair share of the costs. To avoid this free-rider problem, all systemically important institutions are required to participate. And so on. Although contingent capital schemes need further elaboration, they deserve discussion as a complement to the regulatory reforms currently under consideration. Let me stop here for the time being. Thank you for your attention. This is not a remote possibility. In fact, a similar event happened in the current financial crisis. See Augstums, Ieva M., “Berkshire Hathaway subsidiary in Kansas to stop insuring bank deposits above FDIC limit”, Associated Press, September 10, 2008. Chart 1: Rough mapping of events between US and Japan red bracket: major events, blue: monetary policy, yellow: fiscal policy, pink: bank rescues Japan U.S. 4Q 1990 Commercial land price started to decline sharply First Policy Rate Cut July 1991 2Q 1992 20% decline in commercial land price in one quarter Aug. 1992 Jan. 1993 Feb. 2007 Sept. 2007 Oct. 2007 26% decline in ABX-HE (BBB) in one month First Policy Rate Cut 18% decline in ABX-HE (AAA) in four months Citigroup, BoA and JPMC announce plans for $80 Oct. 2007 billion Master Liquidity Enhancement Conduit (to be abandoned in Dec. 07) Govt. announces first significant fiscal stimulus package Financial institutions collectively establish Cooperative Credit Purchase Corporation Feb. 2008 President Bush signs the Economic Stimulus Act of 2008 Sep. 2008 FHFA places Fannie Mae and Fredie Mac in government conservatorship. '93, '94, '95 fiscal stimulus packages Govt. announces full protection for deposits for Jun. 1995 five years (to be extended further) Government establishes Resolution and Collection Jun. 1996 Bank (later to be reorganized as Resolution and Collection Sep. 2008 Corporation) Failure of Sanyo Securities, Hokkaido Nov. 1997 Takushoku Bank, Tokuyo City Bank and Yamaicihi Securities Public capital fund injection to 21 major Mar. 1998 Sep. 2008 bankruptcy protection FRB authorizes FRB NY to lend up to $85 billion to AIG Oct. 2008 Establishment of $700 billion TARP banks (1.8 trillion yen) Introduction of temporary nationalization scheme, new scheme for public capital fund injection and Oct. 1998 etc. Temporary nationalization of Long Term Credit Bank of Japan. '98, '99 Lehman Brothers Holdings files for Chapter 11 Treasury Dept. purchases a total of $125 Oct. 2008 billion in preferred stock in 9 U.S. banks (more to follow) Treasury, FRB and FDIC jointly announce an fiscal stimulus packages Nov. 2008 agreement with Citigroup to provide a package of Feb. 1999 BoJ introduces zero interest rate policy Mar. 1999 guarantees, liquidity access and capital FOMC votes to establish a target range for the Dec. 2008 effective federal fund rate of 0 to 0.25 percent Public capital fund injection to 15 major banks (7.5 trillion yen) Chart 2: Japan’s Real GDP Growth and Fiscal and Monetary Policy %, y/y changes and contributions % at end of FY 4.5 3.5 2.5 -1 1.5 -2 -3 0.5 -4 FY 93 94 95 96 97 98 NetExports Public Demand Monetary policy rate (right scale) 02 03 04 Private Demand RGDP Growth
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Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the London Stock Exchange, London, 13 May 2009.
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Masaaki Shirakawa: Preventing the next crisis – the nexus between financial markets, financial institutions and central banks Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the London Stock Exchange, London, 13 May 2009. * * * Ladies and Gentlemen, I. Introduction It is a great honor to have the chance today to present my views at the London Stock Exchange right at the heart of the City of London. This is the first opportunity for a Governor of the Bank of Japan to speak in the City. Let me extend my gratitude to the three hosts that have made it possible: International Financial Services, London, the London Stock Exchange, and the Japan Society of the United Kingdom. They have all played and are continuing to play critical roles in the development of the City as the world’s premier financial center. Both Japan as a country and the Bank of Japan have had a close relationship with the City since Japan entered the modern era. Japan issued its first government bond here in London in 1870, only two years after the Meiji Government was established. This was to raise funds to build its first railroad between Tokyo and Yokohama, which naturally was built by a British gentleman, Mr. Edmund Morel. The Bank of Japan was established in 1882 and its first overseas office was set up here in the City of London in 1904 at 120 Bishopsgate. At the time of its establishment, assimilating expertise on modern banking business was essential for the Bank of Japan, and young staff members were sent to commercial banks here in the City as trainees. Two of them returned to later become Governor of the Bank of Japan. Over the years, the Chief Representative of our London Office has continued to report back to Tokyo on developments in the London financial market which is an epitome of the global financial markets. Reading the reports in our archives one cannot be but surprised by the fact that financial crises are not necessarily rare events. They have occurred quite often and unfortunately the lessons are also frequently forgotten. Our most pressing challenge today globally is to resolve this crisis and to get the economy onto a stable growth path. But we also simultaneously need to think about how we can prevent the next crisis. On this point, the United Kingdom is demonstrating its leadership as the Chair of the G20, hosting and leading the discussions at the recent financial summit. In March, the Financial Services Authority issued its Turner Review 1 which examines the factors behind the crisis and presents broad-based regulatory and supervisory responses to create a stable and effective banking system. Today, I would like to present to you my views on steps necessary to prevent the recurrence of financial crises, reflecting upon the history of past crises and the interlinkages between financial markets, financial institutions, and central banks. II. Current conditions To set the stage, I will briefly explain the current condition of the Japanese economy and financial system, and then touch upon the global landscape. Japanese banks had relatively limited exposures to complex securitized products and thus the Japanese financial system Financial Services Authority (2009), “The Turner Review”. retained its stability even after the initial shocks during the summer of 2007. However, conditions changed dramatically after the collapse of Lehman Brothers, although stress levels in Japan’s financial markets were milder than those in US, UK, and the euro area. For example, three month Libor-OIS spreads, a signal for assessing tension in money markets, increased in the yen market only to twice the levels seen before the failure, while those in the US dollar, euro and sterling markets spiked to levels three to four times higher. In sharp contrast, when one looks at the impact of the global financial crisis on the real economy, Japan’s real GDP fell the sharpest among the major economies, falling -12.1% on an annualized basis during the last quarter of 2008, though annualization might be misleading in this rapidly changing environment. In any event, the Japanese economy literally fell off a cliff. This large drop is a simple reflection of the fact that the export oriented industries, namely automobiles, electronics, and IT and capex related areas, which were impacted the most by the fall in global demand, have roughly a 50% share of Japanese industrial production. This is much larger than the US and UK where these sectors only have a share of approximately 20%. More recently, we have seen some positive signs as industrial production has increased for the first time in six months. Although we expect the pace of deterioration in economic conditions to moderate gradually and the economy to start to level out towards the end of this year, we are closely watching developments. Why has the global economy weakened so sharply since last autumn? First and foremost, excesses had built up during the high growth period earlier in this decade. Credit bubbles had emerged in several regions of the world which began to unwind rapidly as the financial turmoil unfolded. In this process, the adverse feedback loop between financial and real economic activities has compounded the damaging effects. Second, this was further aggravated by the sudden and severe erosion of confidence in financial markets triggered by the collapse of Lehman Brothers. This further restricted the flow of funds from the financial system to the real economy, and also sharply cut back capital flows to emerging economies. As I mentioned, the Japanese financial markets have been relatively calm compared with US, UK and the euro area. But, still, the effects of the global financial turmoil have been felt through multiple channels. Foreign banks retreated from certain business areas in Japan. Their presence diminished in the yen money market where they had accounted for more than half of turnover before the crisis. In some cases, the Japanese operations of foreign banks faced difficulties in their yen funding. Additionally, the spillover of the shocks from the global financial markets basically froze our CP market and corporate bond market. On another note, as foreign banks came under capital constraints, Japanese banks faced increased demand for foreign currency denominated funds from both foreign and domestic firms. This crisis has once again shown that conditions in the financial markets and financial system strongly influence the real economy, and that financial markets and the financial system are globally interlinked. III. Humbly learning the lessons of history I would like to review a bit of history to pick out what I believe to be commonalities of past crises. 2 Financial crises have occurred repeatedly in history. In Japan, we experienced a major financial crisis shortly after World War I as an asset price bubble collapsed. Following many years of relative calm in the financial system, we experienced our next major financial crisis during the latter half of the 1990s. The total cost of dealing with non-performing loans in this Masaki Shirakawa (2009), “Way Out of Economic and Financial Crisis: Lessons and Policy Actions,” speech at the Japan Society in New York. episode was over 100 trillion yen or roughly 20% of nominal GDP. 12.4 trillion yen of public funds was injected into the banking system as capital. In the UK, in 1890, the bursting of an overseas investment bubble resulted in the Baring Crisis, and more recently, the Secondary Banking Crisis occurred during the 1970s after the collapse of a commercial real estate boom. In view of such historical episodes, we all have to be humble in avoiding complacency. To be specific, we must be mindful of the fallacy of the following two unsubstantiated views. One is that benign economic conditions will continue for an extended period into the future. The other is that policy-makers can deal effectively with the bursting of the bubble through aggressive ex-post monetary and fiscal policy. The key common element of all financial crises is that they are preceded by a period of positive economic performance. For example, in the case of Japan, during the late 1980s, real GDP grew at an average annual pace of over 5% for four years, while CPI remained generally stable staying in a range between slightly negative and 1%. This bred a conviction that the Japanese economy had entered a new era, and in this environment, equity and real estate prices boomed. Globally, after the mid-1980s, the so-called Great Moderation led to a substantial decline in the volatility of output and inflation in many major industrial nations including the UK. I will not get into the debate today about the reasons behind this seemingly great moderation, but this change in the macro-economic environment may have lulled many of us, including central bankers into a false sense of stability. Of course, warnings are raised even during such times. In the late 1980s, senior officials of the Bank of Japan often used the expression "we are sitting on dry fire wood" to explain the precarious situation. The Bank of Japan, to send out a not-too-subtle warning, also published a research paper in 1990 on the UK’s Secondary Banking Crisis and its lessons for the Japanese financial community. Here in the UK, for example, before the current crisis, the Bank of England repeatedly pointed out its concerns in its Financial Stability Report regarding the unusually low risk premia prevalent in the markets and the possibility of sudden drop in asset prices due to a sharp change in the assessment of risks. Nonetheless, the mentality “this time it’s different” always seems to win out, supported by supposedly credible arguments. Warnings often go unheeded and are drowned out by the party music to which everybody is dancing. What hinders us from learning the lessons from past crises despite the fact that crises occur repeatedly? First, memories fade away. As I mentioned, in the current financial crisis, the condition of Japanese financial institutions has been relatively resilient. Fortunately, not much time has passed since Japan's crises during the 90s and senior management still vividly remembers the painful experience. This has led them to be cautious about taking on complicated forms of risk. This might not be the case in the future. Second, though people may witness the bursting of a bubble and the shocks of a crisis in another country or perhaps read about it in reports or history books, it is difficult to really learn the lessons of the crises and to be able to actually take the necessary steps to prevent them, unless one has directly experienced it. Much has been written and presumably read about the Japanese crisis. But whether the lessons have been truly appreciated seems to be a different story. Third, crises are never exactly the same, and each crisis has its own unique characteristics. Japan's crisis and the current global crisis have many common elements, but there are also a number of differences. In Japan's case, the non-performing loans were mostly commercial real estate loans extended by banks and the crisis was basically concentrated in the domestic banking sector. On the other hand, the current crisis is global in nature and covers both capital and banking markets. The tools involved, such as CDO squared and off-balance sheet vehicles, are much more complex, thus making the nature of the crisis more complicated. Additionally, before the current crisis, the pervasive view among policy-makers and academia was that, even if a bubble were to burst, aggressive ex-post monetary easing could prevent a sharp deterioration in economic conditions. I personally was skeptical of this view. Now, the proponents of this view seem to have dramatically decreased as the crisis persists. Central bank policy rates are close to zero and balance sheets have expanded substantially at many central banks. Some central banks have embarked on credit easing policies as well. Nonetheless, the adverse feedback loop between the financial system and real economy stubbornly remains, though there are some slight signs of improvement. I wonder how many still unconditionally embrace the aforementioned naïve optimistic view. In short, policy-makers, private sector entities and academics all need to be humble. We can never say we fully understand the dynamics and interlinkages between the financial and economic systems. IV. Perspectives toward reshaping the global financial system The root cause of problems at financial institutions can be wide-ranging. But, the symptoms typically emerge through the lack of liquidity or capital. The problem is that, when we look back at the summer of 2007, there were no visible signs and the financial environment seemed quite resilient. The capital ratios of the twenty largest commercial banks by asset size in the world, mostly US, UK, Euro area and Japanese banks, were in the range of 10 to 14 percent and were concentrated between 11 to 12 percent, well above regulatory minimums. On the liquidity side, the sense of abundant liquidity persistently remained, as was evidenced by very low Libor-OIS spreads and the narrow bid-ask spreads for complex securitized products. However, since then, the landscape has changed in a way which was almost unthinkable. Of the twenty banks, more than half have received injections of capital from their government. Many banks have also faced liquidity difficulties, as raising funds in money markets became restricted reflecting the sharp drop in market liquidity. Some even have experienced outflows of deposits. Why did both market participants and authorities let their guard down against impending risks? Why couldn’t they recognize the problems beneath the surface and take mitigating actions? Let me raise three facets which I believe are relevant. First, the careful assessment of both funding and market liquidity is essential in today’s financial markets. This has two dimensions. One aspect is the interaction between liquidity and capital. For example, with regard to complex products such as certain securitized instruments, pricing, and as a result, necessary levels of capital to cover risks, are dependent on both market and funding liquidity. Due to their limited market size, when market liquidity drops, prices fall rapidly, putting pressure on banks’ earnings and capital levels. The shortage of capital then constrains the market-making activity of key dealers, further reducing market liquidity. Required capital levels are strongly dependent on the assessment of market liquidity risk, not just the underlying credit risks. There is also the risk emerging from crowded trades, where market participants accumulate similar positions in benign market conditions. When market conditions deteriorate, everyone rushes to close their positions, exacerbating market strains further, hence the fall in prices. The second dimension is the risk of liquidity mismatches when short-term funds cover long-term assets. Although this is fundamental risk of the banking business, it seems to have been underestimated. Before the crisis, market participants assumed that CP and interbank markets would always function and would provide access to sufficient liquidity. This led to the build-up of large liquidity mismatches, for example in SIVs. They also believed in the valuation of AAA-rated assets and assumed little risk was involved. They expected that, when cash liquidity was needed, they could promptly sell such assets regardless of the complexity or the size of the market. This led to a further build-up of liquidity risks. Second, understanding the mechanisms through which leverage builds up and the impact of the unwinding of such leverage is essential. Before the outbreak of the turmoil, leverage had built up both through traditional channels such as repos and through non-traditional channels such as off-balance sheet vehicles and structured credit products. Much of the leverage was parked outside traditional financial institutions and also embedded in complex products held worldwide by various investors. As a result, no one could confidently estimate the overall leverage in the financial system, and thus the depth and breadth of its negative impact, once the cycle went into reverse. Third, assessing the effectiveness of diversification and hedging strategies are important. Market participants need to understand that some risks cannot be truly diversified or hedged away. For example, mortgage backed securities cannot avoid the risks of a macro shock such as a nationwide drop in residential house prices. Hedging often involves taking on counterparty and basis risks. AAA–rated counterparties are not risk free. Hedging strategies tend to lose their effectiveness during times of extreme stress. The risks which seem to have been neutralized under normal market conditions, would reemerge once the conditions sustaining the benign market environment collapsed. The causes of the global financial crisis are multifaceted and there are many lessons to be learned and improvements to be made. If I may repeat what has already been raised by many, the lessons are: market participants must improve risk management; disclosure and transparency must be enhanced to improve the effectiveness of market discipline; authorities must revamp prudential rules and strengthen supervision; and cross-border cooperation among authorities must be further strengthened. Recognizing the importance of all of this, from a central banker’s perspective, let me offer two perspectives which I believe are essential in reshaping the global financial system. Assessing risks on a system-wide basis The first perspective is the assessment of risks on a system-wide basis. As a starting point, it is imperative that overall risks in the financial system are assessed on a macro basis. Risks in the financial system and ultimately in the economy as a whole are not simple sums of the risks held by individual financial institutions. During the build-up of the excesses, senior management of financial institutions did not sufficiently take into consideration, interlinkages among financial markets and the interactions between the real economy and financial markets. Authorities tended to concentrate on regulation and supervision at an individual firm level rather than system-wide analysis which is critical for the stability of the financial system. System-wide risks need to be assessed in two ways. 3 As a starting point, they need to be evaluated on a cross-sectional basis at a specific point in time. Both financial institutions and authorities need to look beyond individual products, risks and institutions. The dispersion and concentration of various types of risks together with how they interact within financial markets need to be evaluated. Additionally, system-wide risks need to be reviewed dynamically as it evolves over time. This is the pro-cyclicality problem, I will touch upon next. Risk exposures which may seem to be reasonable under benign economic and market conditions, may increase dramatically during times of stress. The fluctuation of risks as they change along with macro-economic environment needs to be carefully assessed as well. These steps are quite challenging, but have become essential in this globalized and fast changing financial system. Mervyn King (2009), “Finance: A Return From Risk”, speech at the Mansion House. Mitigating pro-cyclicality The second perspective concerns pro-cyclicality, the feedback mechanisms between the financial and real sectors of the economy. Can we expect financial institutions to take into consideration system-wide implications in making their business decisions? Probably not automatically. Financial institutions face strong competitive pressures. Procyclicality is human nature. Such tendencies could be exacerbated, for example, by short-termism built into compensation schemes. Another element which influences pro-cyclical behavior is the macro-economic and financial environment. Looking back at bank behavior since the beginning of this decade, interest rates fell in a low inflation environment, banks and other market participants initially increased duration risks, by increasing their holdings of longer-term assets. Then they took on more credit risk investing in a wider range of products. As profits pressures increased, they additionally used more leverage to enhance returns. Considering the competitive pressures in the markets, behavior of individual entities was quite rational. This is what “search for yield” is all about. Even though risk management at the institution level regarding individual risk factors may have been appropriate, risks were accumulating on a system-wide basis. What is necessary to avoid such accumulation of risks through pro-cyclical behavior? To begin with, proper incentive structures need to be incorporated into rules and market practice. For example, senior management requires incentive structures which have time horizons that are consistent with the risk profile of the institution. The recently published Financial Stability Forum’s Principles for Sound Compensation Practices 4 highlights this point and such perspectives are also generally relevant in the areas of accounting and disclosure. Not only micro-level incentives, but macro-level incentives also matter. Behavior of economic agents is importantly influenced by overall economic and market conditions. When rival firms are generating excess returns through new strategies in a low interest rate environment, the incentives are clear. As in the now famous remarks, it is difficult not to join the party, if everybody is dancing to the music. This is where policy tools to mitigate procyclicality become essential. Excellent work has already been carried out in various fora such as the Basel Committee on Banking Supervision and the Financial Stability Forum, the new Financial Stability Board, to assess possible pro-cyclicality in current rules, and key areas for further work have been identified such as capital requirements, provisioning, and valuation. Developing a framework whereby banks build up buffers or cushions during good economic times which can be used to absorb shocks during times of stress is required. Policy tools which would enable authorities to steer bank behavior in this direction are called for. Work is continuing but naturally the devil lies in the details. Policy tools need to be dynamic and flexible enough to reflect evolving financial and economic conditions and also deal with the unique condition of each institution. At the same time, they also need to be transparent and market participants would need to be confident in both their effectiveness and fairness. These are challenging conditions, but I am confident the discussions among experts will provide positive results. The important thing is to provide the experts with sufficient time to dig into the heart of the issue and to come up with lasting solutions. Financial Stability Forum (2009), “Principles for Sound Compensation Practices”. V. Actions by central banks Finally, I would like to discuss the roles of central banks which are relevant in preventing financial crises. The central bank is the sole provider of unlimited liquidity and responsible for maintaining the stability of the economic and financial environment. Though the specific details differ across individual central banks, this is traditionally understood to include the following roles: conducting monetary policy aimed at maintaining price stability, acting as a lender-of-last resort, operating and overseeing the payment and settlement system, and in some cases, supervising banks. Today, I would like to talk about the role of central banks from four slightly different angles. Central bank as providers of system-wide analysis First, the central bank is a provider of system-wide analysis. In order to develop a systemwide analytical perspective, both hands-on knowledge of the institution as well as the ability of the central bank’s staff to engage in a constructive dialogue with management of financial institutions are crucially important. In the Bank of Japan’s experience, micro-level supervision, such as on-site examinations and off-site monitoring has been a valuable tool. The Bank of Japan began its on-site examinations in 1928. This was founded on the experiences of the financial crisis during the latter half of the 1920s. The legal basis for onsite examinations was clarified when the Bank of Japan Law was completely revised in 1998. In practice, periodical on-site examinations are complemented by off-site monitoring, including daily liquidity monitoring, which enables the Bank of Japan to continuously assess risks on a system-wide basis. Regardless of which public institution is ultimately responsible for macro-prudential policy, the central bank naturally has a role to play given its unique functions. The central bank has accumulated skills and experience in macro economic analysis and maintains an engrained institutional culture emphasizing the importance of research. The central bank also has access to information through its contacts with market participants and has built up expertise on payment and settlement systems in the course of their banking operations. All of these elements provide a strong foundation for effective system-wide analysis. Central banks as a plumber Second, the central bank is a plumber. When people think about the functions of the central bank, they tend to focus on monetary policy, which is, in recent years, often narrowly defined as the adjustment of short-term interest rates. However, as central bankers have emphasized over the years, 5 in order to effectively implement monetary policy and maintain the stability of the financial system, reliable plumbing including a robust payment and settlement system, is necessary. Markets need an infrastructure, where liquidity flows smoothly and efficiently across products, market participants, time zones and regions. As I mentioned earlier, the current crisis has reemphasized the importance of liquidity. Naturally, central banks need to provide liquidity as the lender of last resort. But it does not stop there. The role of central bank as a plumber is indispensable, even though this is not fully recognized during normal times. For example, the currency swap market is used by banks to access foreign currency funds, especially US dollars. Although it receives little media coverage, the existence of CLS (Continuous Linked Settlement) minimized so-called Herstatt risk which arises when conducting foreign exchange transactions across different time zones, during this crisis. This is a critical risk factor for a country like Japan where markets open first on the globe everyday. Without this system, disruptions in the financial markets during the recent turmoil could have been more severe. Major central banks played a quiet but key role in the establishment of CLS. In other areas, enabling the efficient use of banks’ See, for example, Paul Tucker (2009), remarks at the Turner Review Conference. assets as central bank collateral ensures that sufficient liquidity is available to market participants. Having such infrastructure in place becomes ever more important in stress situations. Foreign currency liquidity operations, typically the US dollar, by non-US central banks are also ways to ensure that liquidity flows to where it needs to go when markets are dysfunctional. Central banks as a global network Third, central banks have become a part of a tight knit global network. Though needless to say there is no single global currency. But financial markets have become globalized. The Nobel Prize winning British economist Sir John R. Hicks made a keen prediction forty years ago. He predicted that in a globalized financial market “a national central bank will no longer be true central bank”, but will become “single banks in a world-wide system”. 6 Of course, each central bank still needs to fulfill its traditional roles within its jurisdictions. But in this globalized financial system, central bank cooperation has become ever more critical, such as the exchange of information and the harmonization of central bank services. Central banks as an entity guided by long-term interests Fourth, economic and financial market conditions evolve continuously and it is impractical for us to foresee all future developments and thus predetermine detailed rules. Central banks are in a position to supplement the limitations of such rules. Recent experiences in monetary policy offer a good example. All central banks have the long-term goal to maintain price stability which is a prerequisite for sustainable growth of the economy. The key is how we define and attain price stability. Almost all central banks have a numerical expression of price stability as they understand, define or target. In the case of Japan, the Bank of Japan has provided its “understanding of medium- to long-term price stability.” The UK has an inflation targeting framework. These numerical expressions play an important role, since independent central banks have to be accountable with respect to their conduct of monetary policy. However, to the extent that a specific number fosters the social presumption that a central bank is expected to focus narrowly on price inflation alone, especially in the short run, it may have the unintended effect of assisting the creation of bubbles when low inflation coexists with an excessive boom in economic and financial activity. If this is the case, it may hinder the central bank’s longer term goal of maintaining stable prices and a stable financial system. A fundamental issue arises when credit bubble emerges in an environment of general price stability. Do central banks hesitate to tighten monetary policy because prices are generally stable? Just as it is important for senior management of financial institutions not to succumb to short-termism exemplified by short-term ROE targets, central banks need to focus on longterm price and financial stability. Needless to say, price stability is essential. But if central banks see the economy only through a lens of narrowly interpreted price stability, they sometimes may overlook much more crucial imbalances. Milton Friedman explained in his famous presidential address to the American Economic Association in 1968, that the role of monetary policy is two fold; maintaining the smooth functioning of financial markets and the financial system, and price stability. 7 What is intriguing here is that Friedman used the term monetary policy in a much broader context than we define now. Would it be appropriate to clearly detach the two objectives of the central bank, and as a result use two separate set of tools to attain them? Simply put, would we use interest rate policy to maintain price stability and introduce separate macro prudential tools to maintain the stability of the financial system? In my view, the two objectives of central banks are closely interlinked. One cannot John R. Hicks, (1969), “Critical Essays In Monetary Theory”. Milton Friedman (1968), “The Role of Monetary Policy,” Presidential Address to the American Economic Association. be achieved without the other on a long-term basis. Thus separating two set of tools also would be impractical. Central banks need one large toolkit to achieve the two inseparable long-term objectives. It is a daunting task for a central bank to act with a long-term perspective while explaining its intention and rationale in a society which is liable to be influenced by short-termism. It is a real challenge. VI. Concluding remarks Let me conclude. International discussions to develop a new financial architecture and new rules which would prevent future crises are underway. However, new architectures and rules in themselves are not sufficient. There is no doubt that through advances in technology and innovation, financial products, institutions, and markets will continue to evolve rapidly. Rules, especially global rules, which require due process before implementation, will inevitably be behind the curve. Using expert judgment to adapt present rules to a new environment will always be important. No amount of rules can guide the ideal response among economic entities, especially against unforeseeable future events. Central banks, through their skills and experience in macro economic policy as well as their unique position in financial markets, can help steer the policy debate in areas such as macro-prudential policy. Central banks, with their macro-perspective towards both the real economy and financial system, expertise as plumbers of payment and settlement system, and real time market intelligence obtained from interaction from market participants can and must play a key role in preventing future crises. This also entails huge responsibilities for central banks and we will need to work extensively both individually and jointly to be in a position to fulfill such a role, together with other authorities. Close cooperation with financial institutions and other market participants will also be crucial. Thank you for your attention.
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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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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. * * * 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. See Shirakawa, Masaaki, "Preventing the Next Crisis: The Nexus between Financial Markets, Financial Institutions and Central Banks," May 13, 2009.
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Opening speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the 2009 International Conference hosted by the Institute for Monetary and Economic Studies, Tokyo, 27 May 2009.
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Masaaki Shirakawa: Financial system and monetary policy implementation – long and winding evolution in the way of thinking Opening speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the 2009 International Conference hosted by the Institute for Monetary and Economic Studies, Tokyo, 27 May 2009. * * * Introduction Good morning. I am very pleased to address the Bank of Japan international conference. On behalf of my colleagues at the Bank of Japan, I welcome all the participants from central banks, international organizations, and academia. Interaction between financial system and monetary policy This year’s conference focuses on the theme of “Financial System and Monetary Policy Implementation.” The two things in the theme are closely interacted. That interaction has been consistently posing important policy challenges to the Bank of Japan since the late 1980s when bubble emerged. That seems to be increasingly the case for central banks in other countries as well. In fact, the interaction has gradually but steadily attracted both policymakers and academics, and has become a popular theme for research conferences. We have certainly benefited from such developments. For this conference, leading economists have contributed six stimulating papers. Distinguished policymakers are getting together to discuss the current policy challenges at the policy panel session. I look back, with somewhat mixed feelings, on the past discussions on the policy responses to the bubble and its burst. Several points come to mind immediately: Twenty years ago when Japan’s bubble was at its peak. Ten years ago when Japan’s financial crisis was at its peak. Several years ago when the global economy was in the era of “great moderation.” Two years ago when the global credit bubble came to the surface as the U.S. subprime mortgage problem. And even more recently just at this time last year. I see long and winding evolution taking place in the way of thinking over time. Up until the mid 2000s, Japanese participants in international conferences, including myself, often felt frustrated both at home and abroad: on the one hand, the delay in necessary actions at home such as injection of public capital, and, on the other hand, the difficulty in sharing the economic reality in Japan under the malfunctioning financial system after the burst of the bubble. 1 The delay in policy actions was in part due to the political difficulty of persuasion. One factor behind seems to be the fact that financial institutions were unpopular, as always. But, most fundamentally, we were not equipped with economic theory to fully address the core of the problem. In those days, we made the most of academic wisdom, but we often encountered the situations that were not well captured by the existing economic theory. For example, financial imbalances were built up under benign economic conditions, through sharp credit expansion, outsized leverage, and soaring asset prices. 2 After the burst of the bubble, market participants suddenly lost their confidence and reduced their risk-taking capacity. As a result, Japan’s 1990s is often referred to as the “lost decade.” For the appropriateness of such characterization and policy responses, see Shirakawa (2009a). Among the papers contributed to the conference, Hattori, Shin, and Takahashi (2009) revisit Japan’s bubble in the 1980s by shedding light on the changes in money flow behind the expansion of the bubble. the effectiveness of monetary policy was severely constrained. Further monetary policy responses with unorthodox measures were adopted. The effectiveness of monetary policy measures crucially depends on the central bank’s credibility, which is partly affected by the soundness of central bank balance-sheet and central bank’s neutrality perceived by the public at large. All in all, those experiences seem to show that textbooks on macro and monetary economics need some new chapters on the interaction between the financial system and monetary policy. The way of thinking about monetary policy management has certainly changed since the outbreak of global financial market turmoil in the summer of 2007. In particular, since the collapse of Lehman Brothers in September last year, the policy discussions have changed further with the first-hand experiences of the downward spiral in both the financial and real sectors of the economy. It has turned out that Japan’s experience is no longer unique. Adoption of unprecedented policy measures: Japan’s experiences I will provide a basis for discussion by reviewing the Bank of Japan’s policy implementation during the financial crisis after the burst of the bubble, especially since the late 1990s. Of course, various measures were taken in the fields of central banking. Here my focus is on monetary policy. The Bank of Japan’s policy responses can be summarized into five points. First, the Bank lowered overnight interest rates in the interbank market down to virtually zero, eventually just one-tenth basis points (0.001 percent). Second, the Bank provided ample excess reserves by using various tools for monetary operations, including an increase in the outright purchase of long-term government bonds. For the smooth provision of ample liquidity, the maturity of monetary operations lengthened, running for ten months in bill-purchase operations at the final stage of the quantitative easing policy. “Quantitative easing” is often used in a rather vague manner, but the policy action we adopted can be regarded as a pure form of “quantitative easing.” Third, the Bank adopted “credit easing” in the current terminology. The assets purchased included asset-backed securities (ABSs) and asset-backed commercial papers (ABCPs). Fourth, the Bank made a commitment to continuing with the zero interest rate policy and the quantitative easing policy. The conditions for commitment were expressed as “until deflationary concerns are dispelled” at the time of the zero interest rate policy and “until core CPI inflation becomes stably zero or above” at the time of the quantitative easing policy. Fifth, the Bank took unprecedented measures to secure the stability of the financial system, including purchases of stocks held by financial institutions. You may find the striking similarities between the policy measures formerly taken by the Bank of Japan and those currently taken by central banks in major countries. I never imagined that a host of unconventional measures taken by the Bank of Japan would be adopted by other central banks just a few years later. I also guess that my colleagues at central banks in other countries never imagined employing such policy measures. Of course, such measures are not perfectly identical, reflecting the differences in the structure of financial intermediation and severity of stress in financial markets, as well as the differences in legal and social restrictions on policy measures available for central banks. Notwithstanding such differences, the aforementioned striking similarities stand out. It is quite natural that a central bank facing a financial crisis takes similar measures, because a central bank, after all, pursues the same objectives with the same capacity, that is, the capacity to adjust the amount of liquidity in the economy. 3 Among the papers contributed to the conference, Goodfriend (2009) argues central banking under financial turmoil by classifying central bank initiatives into monetary policy, credit policy, and interest rate policy. Importance of liquidity This leads me to discussing liquidity, which, I think, is the most important concept in understanding the current financial crisis, though it is hardly possible to sort out a single factor. During the expansion period of the credit bubble, it was complacency based on unfounded expectations about the unlimited availability of liquidity behind the aggressive risktaking attitude. By contrast, during the period of bubble bursting, it was fear of the exhaustion of liquidity that caused an extraordinary contraction of economic activity. In addition, liquidity conditions significantly changed the valuation of financial assets, thereby influencing the capital positions of financial institutions. Here, I use the term of “liquidity” as the concept incorporating both funding liquidity and market liquidity. But I have to admit that “liquidity” is hardly defined precisely and measured exactly in a quantitative manner, and thus it remains somewhat elusive. Nevertheless, anybody can surely assess “liquidity” to a certain extent. After all, liquidity is the core concept in understanding interdependence between the real and financial sectors of the economy from the beginning of central banking. The principal function of central banks has been and will be the guardian of liquidity. From the standpoint just I mentioned, it is crucially important for a central bank to adequately control the aggregate amount of liquidity in the economy. Please note, however, that the concept of liquidity here does not necessarily correspond just to the terms of broad monetary aggregates or reserves. In fact, the reversed correlations between money stock and economic activity are almost consistently observed in recent years in Japan: money stocks increase when economic activity weakens, while they decrease when economic activity expands. The money multiplier is also quite unstable. Challenges for central banks If this is the case, what does it mean practically to say liquidity is important? I will touch briefly upon some issues and challenges for central banks, based upon the recent experiences. First of all, I want to draw your attention to a fine line between liquidity provision and capital provision. Currently, central banks are faced with an imminent challenge of implementing unorthodox policy measures. The traditional role of a central bank is in providing liquidity. In times of crisis, a central bank attempts to provide liquidity aggressively sometimes with taking some credit risk. The relaxation of collateral eligibility is a case in point. In a dysfunctional market where prices are not “discovered,” it is not so certain that a central bank is protected from credit risk, even if central bank lending is “collateralized.” That makes it difficult to distinguish liquidity provision from capital provision. Outright purchases of credit instruments imply that a central bank shoulders credit risk in a more straightforward manner. In that regard, monetary policy approaches the region of fiscal policy. Under such circumstances, a central bank should be cautious about the risks of undermining its credibility which is prerequisite for any policy implementation. The issues such as deterioration in financial soundness and massive intervention to resource allocation at an individual level are now recognized. Central banks in major countries manage to strike a balance between the ultimate responsibility of maintaining price and financial stability on the one hand and the accountability in a democratic society on the other hand. Although there is no clear-cut answer holding true universally, the public needs to understand the role of central banks correctly. Second, central banks are supposed to work hard as a “plumber” in facilitating the smooth and efficient flow of funds. 4 An important area is the payment and settlement system and our See Tucker (2009). own procedure of monetary operation. Taking an example of the cross-border collateral arrangement, the Bank of Japan decided last week to expand its eligible collateral to foreign government bonds denominated in foreign currencies as a temporary measure. That arrangement enables financial institutions to use foreign currency denominated foreign bonds as collateral for yen-fund provision operations by the Bank. Third, redesigning financial regulation and supervision, jointly with other relevant authorities, is called for. 5 In view of the current crisis, not only credit risk but also market and funding liquidity risk need to be addressed. Specifically, the problem of pro-cyclicality should be addressed by establishing proper incentive structures for rules and market practices to control the incentives at both micro- and macro-levels. Last but not least, I will draw your attention to how monetary policy should be conducted, once we fully recognize the importance of liquidity. Here, research activity at central banks is crucial. For example, the current financial crisis sheds light on the risk-taking channel of monetary policy, stemming from the changes in liquidity conditions. The risk-taking channel works in the nexus between monetary policy and behavior of financial institutions. 6 The prolonged low interest rates under benign financial and economic conditions tend to create over-confidence and thus boost asset prices and collateral values as well as incomes and profits, thereby leading to affecting risk perception as well as enhancing risk tolerance. As a result, aggressive risk-taking behavior in the financial system surges, while a resultant buildup of financial imbalances is likely to be left unchecked. Such financial imbalances come to the surface only once the economic environment starts deteriorating. Considering the complicated transmission channel and the behavioral aspect of various economic agents, how to frame monetary policy is quite a challenge. For instance, in its explanation, the time horizon for monetary policy needs to be extended, compared with the standard time horizon generally assumed in the formal inflation targeting. In this case, another important policy challenge is posed as to how to ensure the transparency of monetary policy. Closing remarks Let me conclude now. In response to the current financial crisis, the policy discussions are continuing about wide-ranging issues on not only monetary policy management but also financial regulation and supervision. Dialogue between academics and policy makers plays a crucial role in discussing and formulating necessary actions in both short- and medium- to long-term perspectives. In that regard, I am convinced that this year’s conference will produce further insights into more effective central bank policy making. Thank you. References Borio, Claudio and Haibin Zhu, “Capital Regulation, Risk-taking and Monetary Policy: a Missing Link in the Transmission Mechanism?,” BIS Working Paper No. 268, 2008. Goodfriend, Marvin, “Central Banking in the Credit Turmoil: An Assessment of Federal Reserve Practice,” mimeo, 2009. Hattori, Masazumi, Hyun Song Shin, and Wataru Takahashi, “A Financial System Perspective on Japan’s Experience in the Late 1980s,” mimeo, 2009. See also Shirakawa (2009b). See Borio and Zhu (2008). Shirakawa, Masaaki, “Way Out of Economic and Financial Crisis: Lessons and Policy Actions,” Speech at Japan Society in New York, April 23, 2009a. ________, “Preventing the Next Crisis: The Nexus between Financial Markets, Financial Institutions and Central Banks,” Speech at the London Stock Exchange, May 13, 2009b. Tucker, Paul, “Remarks at the Turner Review Conference,” March 27, 2009.
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Remarks by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the International Monetary Conference, Kyoto, 9 June 2009.
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Masaaki Shirakawa: The role of central banks in the new financial environment Remarks by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the International Monetary Conference, Kyoto, 9 June 2009. * * * Introduction Let me first thank the hosts for inviting me to the International Monetary Conference. The IMC has a very long history of providing not only its private sector members, but also the public sector with an excellent opportunity to frankly discuss a broad range of issues regarding financial institutions, financial markets and the financial system. We are unfortunately still in the midst of an unprecedented financial crisis, although hopefully the worst is behind us. The topic the organizers have given to us central bankers, "The Role of Central Banks in the New Financial Environment", is clearly a very timely one, something which is on our minds everyday. The fundamental role of a central bank remains unchanged, but its functions have gradually changed with the passing of time. In the case of the Bank of Japan, on-site examinations of financial institutions were introduced in 1928 based on the experience of the financial crisis after World War I. The Bank of Japan Act was revised in 1998 to strengthen the independence of monetary policy. This reflects, among others, the lessons learned regarding the conduct of monetary policy during the bubble period of the latter half of the 1980s. At that time, our on-site bank examination was also given a clear legal backing. How will the role of the central banks around the world change in light of the current global financial crisis? In considering this issue, I would like to first pose two questions to the top executives that are here with us today. First, in the years heading up to the crisis, especially the five year period between 2003 and 2007, did you recognize that risks were building up in your institution and/or in the financial system? Second - this is a question about the now famous quote regarding dancing with the music - if we were in the future to experience a similar benign economic period of high growth, low inflation, low interest rates and low market volatility, would you choose a different business strategy? If you were to choose a different strategy, what would be your expectations on the path that senior executives of your rival institutions would choose? While you are responsible for making your bank both profitable and resilient to shocks, the role of the central banks is to assure that your endeavors lead to a sound financial system conducive to economic prosperity. What we central banks need to understand is that the behavior of market participants will be influenced by human nature and competitive pressures in the markets. Without trying to paint a complete picture, let me raise a number of issues with respect to the role of central banks which I believe are important in the new financial environment. Role of central banks Assessing risks on a system-wide basis First, central banks need to assess risks on a system-wide basis taking into consideration the linkages between the real economy and financial markets as well as among financial institutions. Such assessment will be the basis for policy actions regarding financial system stability. Of course, this is a typical example of something that is easier said than done. Before the current crisis, central banks issued warnings regarding the build-up of risks through financial system reports. However, issuing warnings are not so difficult. Senior bank executives and other market participants themselves, to some extent, recognize such risks. If we seriously wish to reduce such risks, remedial action is required. But in order to go beyond analysis and take remedial actions, a proper assessment, a strong will, together with a robust legal framework which enables effective action, are all necessary. In any event, without a system-wide assessment, no actions are possible. I believe central banks are in a natural position to take up such an assessment role. As the entity responsible for monetary policy, central banks focus on macro economic conditions, have close contacts with financial market participants, and our institutional culture emphasizes the importance of research. Reconsidering the conduct of monetary policy Second, we need to reconsider the conduct of monetary policy. When one looks at market participants and senior bank management collectively, their incentives are also influenced by macro economic and financial conditions. The most typical example would be the search for yield witnessed during the so-called Great Moderation. This incentive issue evolves into a difficult challenge for monetary policy when asset bubbles emerge. The problem is often debated simply as whether monetary policy should lean against the wind or excessive asset price increases. However, I believe that such a formulation of the issue confuses the discussions on monetary policy. No central banker believes that bubbles can or should be prevented just through monetary policy. A more practical formulation of the issue for central banks would be, "how should monetary policy be conducted in an environment where asset prices are rising, credit and leverage are increasing and the economy is growing, strongly signaling a need for policy tightening, while only general prices remain stable?" In such a bullish atmosphere, raising policy rates somewhat would have little short-term effect in dampening bubble-like economic activity. On the other hand, if the central bank maintains very accommodative monetary policy, this would amplify the expansion of credit and leverage. When we debate the relationship between monetary policy and bubbles, we can neither be too optimistic nor too pessimistic. The build-up of excesses cannot be constrained by monetary policy alone. We need a combination of policy measures. At the same time, if monetary policy is inappropriate, the bubble will grow even more, eventually bursting and causing a sharp contraction of the economy. Revamping prudential regulation Third, central banks need to contribute to the on-going debate in revamping prudential regulation. Central banks may or may not be the regulatory body depending on each country's legal framework. Nonetheless, regardless of the legal framework, central banks, which are responsible for the stability of the financial system, can and should play a constructive role in designing prudential rules. The behavior of financial institutions is strongly influenced both by the macro economic environment and by prudential rules. As a specific example, prudential rules such as regulatory capital requirements and bank practices such as provisioning need to be reviewed with the aim of reducing pro-cyclicality. A framework whereby banks build up buffers during good economic conditions so that they can use such buffers to maintain their financial intermediation function during difficult macro conditions is essential. Strengthening the provision of banking services Fourth, the banking services central banks provide need to be strengthened. In recent years, central banks have taken multiple steps to enhance the stability and efficiency of the payment and settlement system, such as steps to minimize settlement risks emerging from time zone differences in foreign exchange transactions and enhancing payment and settlement system oversight. During this crisis, in the area of money market operations, central banks have expanded the range of collateral and counterparties, and major central banks have conducted coordinated operations to provide US dollar liquidity. These measures have helped bring back stability to financial markets. However, in ever-changing financial markets, challenges remain. It is often mentioned that financial markets are gradually becoming seamless in a figurative sense. But, it is far from seamless even if it were limited to financial transactions and their settlement. During the day, incoming payment instructions and outgoing payment instructions are not completely synchronized, and thus the need for intraday credit emerges. This is most typical in foreign exchange transactions, although such risks have been reduced through the introduction of CLS. Additionally, market volatility can suddenly increase short-term funding needs, as financial institutions require additional collateral under margining arrangements. As a result, in the process of financial transactions, leakages of liquidity or temporary storage of liquidity become inevitable, and seams emerge. In times of crisis, the shortage of liquidity caused by such seams can aggravate the situation. Central banks will need to continuously review how our banking services can fill such gaps. Enhancing organizational culture and human capital In concluding I would like to emphasize the importance of the organizational culture and human capital at both central banks and the private sector. Organizations cannot flourish without a rich culture emphasizing fundamental aims and without a deep pool of human capital embodying such a culture. First, both central banks and financial institutions need to cultivate a culture emphasizing the importance of maintaining a long-term perspective. Otherwise, both cannot attain their goals on a sustained basis: long-term macro economic and financial stability for central banks and long-term profitability for the private sector, respectively. Second, in the case of central banks, we need to be in a position to help fill the gaps of incomplete contracts and markets. Financial transactions are concluded using various forms of contracts, and it is impossible to prepare a contract which can cover each future state. Using economics terminology, "complete contracts" do not exist. A central bank can, for example, function as an honest broker or a catalyst, in supporting the development of a market-based solution to a newly emerging issue. In order to be in a position to fill such gaps, it is critical that central banks are sensitive to changes in the financial markets and financial industry. However, since central banks are not profit motivated organizations, there is the risk that we do not promptly recognize such changes. On the other hand, individual financial institutions and other market participants do not necessarily have the incentive to internalize the possible effects of their behavior on the overall financial system. Maintaining stability in the financial system would not be possible without cooperation between central banks and the private sector. Central banks need staff who have excellent people skills to cultivate constructive relationships with financial institutions and market participants, understand the details of business practices, and honed their macro perspectives. One of the important roles I have as governor of a central bank is to cultivate such an organizational culture. In a similar vein, I hope you can foster a culture within your institutions that recognizes the importance of our collaborative efforts and would support our work by informing the public sector in a timely manner of possible buds emerging in the economy or financial markets which may harm the stability of the financial system. As I mentioned at the outset, the IMC provides an excellent opportunity for such dialogue. I will stop here. Thank you.
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Speech by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at the Japan Society of Monetary Economics Spring Annual Meeting, Tokyo, 16 May 2009.
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Kiyohiko G Nishimura: Financial system stability and market confidence Speech by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at the Japan Society of Monetary Economics’ Spring Annual Meeting, Tokyo, 16 May 2009. * 1. * * Preface I am grateful for this opportunity to speak before the time-honored Japan Society of Monetary Economics. Taking advantage of the occasion to address leading scholars, I would like to make half of my remarks today as a Deputy Governor of the Bank of Japan, and the other half as a former Economics Professor of the University of Tokyo, where we meet today. I hope that I can in some way contribute to your debates over the current financial crisis. When Lehman Brothers went bankrupt last September, the financial crisis entered a new level of acuteness, though more recently it has begun to subside thanks to bold policy initiatives taken by countries around the world. Nevertheless, the financial crisis has had significant negative impacts on the real economy. The IMF has revised its 2009 real growth rate forecast for the world economy down to negative 1.3 percent. At the current point in time, the Japanese financial system is stable on the whole and our financial institutions remain sound. However, it is also a fact that Japanese financial institutions are facing a much more difficult earnings environment. We will therefore continue to carefully monitor whether the banking sector is able to maintain a sufficient level of robustness and appropriately provide financial intermediation functions. While governments and central banks have been focused on current crisis management, the G20 Summit and many other fora have seen vigorous discussions of policies that will prevent recurrence of financial crisis. However, the primary interest in most of these debates is how to strengthen regulation, and it is my impression that critical re-examination of the effectiveness of existing regulations or consideration of the possible side effects of reregulation have taken a back seat. As a central banker whose mission is to maintain the stability of the financial system, I believe we should genuinely reflect whether our previous policies led financial institutions in the correct direction. Where there are mistakes, we must correct them and help financial institutions to set off again on the proper path. At the same time, we should recognize that regulation must not impede the growth of the financial services sector. The ultimate goal of regulation should be the creation of a sufficiently flexible financial system that is able to smoothly absorb internal and external shocks. In my remarks today, I would like to focus on how we design systems that will prevent the recurrence of financial crisis, and consider this from a broad perspective that is not bound by established concepts and approaches. Obviously, the design of desirable policies and regulations requires a deep understanding of what is behind the crisis. Therefore, while it may strike many of you as being a bit roundabout, I would like to begin my remarks by reviewing the background to the current crisis and the mechanisms that have exacerbated it. 2. Emergence of the "credit bubble" 1 At the outset, I would like to set out the causes of the current financial crisis in my own way. We are currently in the midst of financial crisis. The global financial system may be in a lull, but we do not know when another challenging issue could erupt. The situation surrounding us does not allow for premature conclusions. Therefore, I would like to ask you to understand that my remarks are based on the information that is available to us at the current point in time and necessarily represent a provisional diagnosis. No one would deny that the prologue to the current financial crisis was the subprime housing loan crisis in the United States. But that was essentially a problem in a portion of the home mortgages in a single country – albeit the United States – and it would normally be inconceivable for that alone to plunge global financial markets into chaos. It is therefore more appropriate to look to macro global problems as the true background to today's financial crisis. It is undeniable that the low interest rates and excess liquidity that have prevailed around the world since the collapse of the IT bubble are behind the crisis. In that sense, we were in a situation in which it would have been quite plausible for a financial crisis to occur anywhere and in any form. Why did the US subprime housing loans trigger the crisis? The US current account deficit has begun to expand rapidly since the latter half of the 1990s. Meanwhile, emerging Asian economies, including China and oil producing countries, have begun to see their current account surpluses expand. This is the phenomenon that has come to be called "global imbalances." I am sure that you will recall a variety of discussions over whether this situation would be sustainable. In fact, when there are significant differences in the degree of development of individual countries' financial markets, a situation like the global imbalances that appear on the surface to be a disequilibrium can in fact be one kind of equilibrium itself. 2 In emerging economies and oil producing countries, many imperfections may be observed in the domestic financial markets. Stock markets are undeveloped, deposit interest rates are fixed at low levels by regulation, and so on. Because of this, these countries may lack financial assets that offer a safe store of wealth gained by rising incomes. One solution is to purchase "safe" financial assets from other countries. The development of information and telecommunications technologies has made it far easier to purchase foreign assets than it was in the past. And it was the United States that supplied those "safe" financial assets. For emerging economies and oil producing countries, this translated into current account surpluses, since the purchase of foreign assets is, ultimately, the export of capital. Conversely, for the United States, this resulted in current account deficits because the savings shortfall due to excess consumption was covered by importing capital. This set the stage for the spread of a USmade "credit bubble" to the rest of the world. Obviously, the global imbalance on its own is insufficient to generate a "credit bubble" that is completely divorced from economic fundamentals. For that, we must turn to the problems inherent in the process by which subprime housing loans were turned into securitized The word "bubble" should be used according to its strict economic definition, but usage is often much looser, as can be seen in policy debates, for example. In this paper, I have placed "credit bubble" within quotation marks to indicate that is being used colloquially rather than in its strictly defined sense. Cabarello, R. J. (2006), “On the Macroeconomics of Asset Shortage,” The Role of Money: Money and Monetary Policy in the Twenty-First Century, The Fourth European Central Banking Conference, 9-10 November 2006, edited by Andreas Beyer and Lucrezia Reichlin, pp. 272-283. instruments. On this point, I would like to focus on the question of the agency problem and how it relates to the expansion of the securitization business. 3 The primary characteristic of the securitization business is its complexity. Today's securitized instruments have extraordinarily complex structures. For example, they bundle together thousands of subprime housing loans, dissect the cash flow that these loans produce and turn them into a number of different financial instruments with different levels of priority. Furthermore, these financial instruments are again bundled together and chopped up to create more financial instruments. As this process of synthesis and partition is repeated, the risk structure becomes too complex and it is no longer an easy task to measure risk exposure. Certainly, one could argue that instruments should not be purchased if the risks are not clear, but what happened was that many investors placed excessive faith in the ratings issued by ratings agencies for these securitized instruments and began to gobble up complex products regardless. There is the second feature of securitization that we must also discuss: "functional differentiation." Most of the subprime housing loans in the United States were issued by financial operators called "mortgage banks." Instead of continuing to hold the credits after making the loan, these operators sold them to investment banks and other institutions. Investment banks and others then took the home mortgage credits that they had purchased, pooled them together and used them to back securitized instruments that were sold to investors. This is called the "Originate To Distribute" (OTD) model, whose process starts with the origination of home mortgages and ends with the sale of securitized products based on them. One of the problems with the OTD model is that it lends itself to moral hazards. If mortgage banks are able to sell home mortgage credits and transfer the risks, they have no incentive to seriously screen the loans. It is not hard to imagine loans being made to applicants who could not meet credit standards in normal times. This is a typical moral hazard, and I believe it is what planted the seeds of the "credit bubble." Through this process, an enormous volume of securitized instruments backed by and related to subprime housing loans came onto the market. Moreover, many of these instruments were given "AAA" ratings, indicating the highest levels of creditworthiness. What is surprising is that the yield on these AAA-rated securitized instruments was often much higher than the yield on Treasuries even though they also had the same AAA rating. Had market functioned normally, this price distortion could not have been maintained over the long term. But in point of fact, no one questioned this state of affairs; not the banks, not the rating agencies, not the investors, not the regulators. Whether people thought the situation strange or not, everyone seems to have agreed to ignore it. Why could such an abnormal situation continue for so long? Some would argue on this point that an important factor came from organizational behavior and a certain "responsibility avoidance" attitude on the part of organization members – what is referred to in the literature as "plausible deniability". 4 The sellers of securitized instruments maintain that they bear no responsibility, and to demonstrate that there were no problems with their instruments they point to the fact that other operators were selling the same kinds of instruments. They claim that they, like others, calculated the prices of their instruments on the basis of historical data and experience, and they were given the blessing of ratings agencies. In other words, nobody could have possibly foreseen the current price drops, and therefore nobody is responsible. It just happened. Meanwhile, the buyers of securitized instruments – institutional For a more detailed analysis from a slightly different perspective, see the following. Nishimura, K. G. (2007), "Lessons from the Subprime Debacle: The Trust Is the Key in the Rating of Securitized Instruments", Nikkei Shimbun "Keizai Kyoshitsu," 14 December 2007 (in Japanese). Calomiris, C. W. (2009), “The Subprime Turmoil: What's Old, What's New, and What's Next,” in: Maintaining Stability in a Changing Financial System,” Federal Reserve Bank of Kansas City, pp. 19-110. investors – use the similar logic to justify their purchases. Everybody else was buying the same financial instruments and nobody had a problem with it, the excuse goes. It is natural to believe that this plausible deniability was one of the reasons that the “credit bubble” in securitized instruments emerged and was maintained for such a long period of time. Along with the emergence of the “credit bubble,” there is another feature that distinguishes the current crisis – the fact that virtually very few market participants believed that such a serious financial crisis could actually occur. How is it that market participants came to believe this? It has something to do with the phenomenon of so-called "Great Moderation." Beginning in the 1990s, the United States and other countries saw a significant decline in the volatility of their GDPs and other real economy indicators and, as a result, the volatility of financial indicators was stable as well. This situation remained in place for a long time and presumably market participants had an illusion that the same situation would persist in the future and economic upheavals could never occur. There is an opinion that such an illusion was reinforced by the "Greenspan Put," named after Alan Greenspan, former chairman of the Federal Reserve Board (FRB). In other words, even if financial crisis were to occur, former chairman Greenspan and the FRB would certainly be able to use monetary policy to fix it. If the Greenspan Put were true, it could be rational for market participants to take risks on the assumption that the tail risk (the rarely-occurring risk such as financial crisis) would never emerge. In short, the misplaced faith of market participants in monetary policy generated overconfidence in the market. 3. Erosion of confidence and deepening of the crisis I would now like to turn to the collapse of the “credit bubble” and the deepening of the financial crisis that resulted. One of the distinguishing features of the current financial crisis is the liquidity crisis caused by the materialization of counterparty risk. On July 10, 2007, S&P and Moody's announced that they would be reviewing the ratings of several residential mortgage-backed securities (RMBS) backed by subprime housing loan assets. As a consequence, the AAA ratings of asset-backed commercial paper (ABCP) backed by these instruments were also downgraded. Indeed, an unremarkable change in the ratings of risk assets that were not all that important in the context of the market as a whole directly shook the global financial system. In the United States, money market funds (MMFs) have been considered to be extremely safe financial assets. One of the primary reasons for this is that MMFs are only allowed to invest in AAA-rated assets. When ratings were downgraded for ABCP, MMFs did not reinvest. Naturally, funds that originated ABCP and used it to raise money found themselves in fund-raising difficulties: Funds under the Bear Stearns umbrella went bankrupt; BNP Paribas moved to freeze its affiliated fund’s new applications and redemptions. The structured investment vehicles (SIV) created by banks to issue ABCP were unable to find funding sources, and then these banks were forced to provide liquidity enhancement instead. Banks, which frequently lend each other money, suddenly became aware of counterparty risk, the risk that the other party of a transaction might suddenly go belly up. They began to worry that some bank somewhere might suddenly be unable to secure liquidity and fail. Indeed, on August 9, a liquidity crisis actually occurred, with liquidity drying up quickly in the interbank market. The event has come to be known as the "Paribas Shock." Many European banks were among those facing liquidity difficulties. Confronted with this situation, the European Central Bank (ECB) promptly announced that it was prepared to supply massive amounts of liquidity into the short-term money market. 5 In point of fact, MMFs played a role in deepening the crisis during the "Lehman Shock" of September 2008 as well, as will be discussed below. The Reserve Primary Fund, a major independent MMF, held large amounts of CP issued by Lehman Brothers. The fund incurred large losses because of the bankruptcy, plunging it into Some argue that there may be an excessive maturity mismatch on financial institutions’ balance sheets as a background factor that triggered the liquidity crisis. Certainly, a close observation of the facts in the current financial crisis exposes not only the maturity mismatch but also the "liquidity uncertainty" that is the fundamental risk inherent in all financial instruments. It is a truism that liquidity is largely unrecognized while it exists and only understood once it disappears. For example, the design of ABCPs assumes that they can be sold on the market at any time if necessary, but when crisis actually occurred, these instruments could not immediately be sold. Had institutional fund-raising been a little more long-term, there would have been a time cushion that might have enabled them to deal with the crisis in liquidity. Although it may not be possible to take every possibility into account in the selection of assets, a constant awareness of the uncertainty of liquidity and continuous assessment of the maturity gaps between assets and liabilities are key factors in improving the soundness of financial institutions. One often-heard opinion is that credit default swaps (CDS) and other financial derivatives amplified the instability of the financial markets in the current financial crisis. Opinions will differ on the merits of CDSs themselves, but no one would deny that the dysfunction of the over-the-counter (OTC) market, where these instruments were primarily traded, undermined confidence in financial markets as a whole. On September 15, 2008, Lehman Brothers declared bankruptcy. Right around the same time, the market began to talk about American International Group, Inc. (AIG) being on the rocks as well, and its share price plummeted. AIG sold large volumes of CDS protection, in which it was believed that there were many contracts that used Lehman Brothers as a reference company. The bankruptcy of AIG would nullify CDS hedges. Were this to happen, financial institutions that had dealings with AIG would be unable to fulfill their CDS contracts with other financial institutions, raising the specter of a chain reaction. Market participants were suddenly forced to recognize this counterparty risk. Faced with these circumstances, the US government had little choice but to place AIG under its de facto administration. Most CDSs are traded directly. As long as counterparty risk is limited to the parties directly involved in the negotiated transaction, the market as a whole does not recognize any broad risk. The reason the market as a whole became aware of this risk is that the market participants recognized that they are in complex intertwined relationships among themselves arising from the negotiated transaction network. If counterparty risk is recognized in some transaction somewhere – in other words, if there is thought to be a risk that the other party will go bankrupt – everyone who has dealings with that party is at risk of being pulled down too in a chain reaction of bankruptcies. So the initial counterparty risk spreads and spawns new counterparty risks for the parties that have dealings with the counterparty. These "network externalities" certainly played a major role in the process by which the current financial crisis expanded. Counterparty risk can be significantly reduced by centralizing transactions (institutionalizing a "central counterparty"), but in practice, many of the transactions were so complex that the creation of a central counterparty was a daunting task. I do not think that the current sense of paralysis that pervades financial markets can be explained merely as the rupture of a “credit bubble.” When bubbles rupture, one would ordinarily expect economies to return to their fundamentals. In other words, economies get back to functioning as they should. But I do not think there is anyone who would say that economies at the moment are functioning properly. The global economy today has fallen far beneath its potential and is seemingly unable to pull itself up. The root cause of this is the erosion of confidence in the market. When confidence is eroded, market participants become extremely fearful that they might be confronting a completely "break the buck" (net assets per dollar face value worth less than one dollar) status. This greatly undermined the confidence in MMFs as a whole, triggering a rapid outflow of money that translated into a major upheaval for the short-term money markets. unpredictable and uncertain world. In this case, for market participants who want to behave rationally, the most natural course is to assume the most pessimistic scenario and make the best of it. 6 Such market participants will react more readily to bad news, to information about the worst conceivable circumstances, than they will to good news. What is more, in situations such as these, market participants tend to adopt a strategy of standing still until confidence has been restored. 7 Actions that may be rational at the level of individual market participants can lead to a "fallacy of composition," which delays the restoration of functions for the market as a whole. 4. Institutional issues on the financial system I would next like to explore the background of the current financial crisis from the following two perspectives: monetary policy implementation and financial system design. Let me begin by considering monetary policy in the context of the so-called “bubble” phenomena. It is extremely difficult for central banks to be aware in real time of the emergence and collapse of “bubbles”. 8 There are two schools of thought about how to deal with bubbles. One says that you should wait and clean up after the collapse because it is difficult to be aware of bubbles as they emerge. The other argues that they should be dealt with quickly by reading the signs of a bubble from numerous indicators like asset prices. Both positions, however, acknowledge that it is difficult to identify the emergence and collapse of bubbles in real time. When a large bubble collapses and severely damages the financial system, monetary policy has extremely limited effects, as we have seen in the current financial crisis. Furthermore, if the process of bubble formation involves "Greenspan Put"-type expectations among market participants, it may lead to excessive risk-taking activities. Thus, the current financial crisis raises the extraordinarily difficult question of how central banks should conduct monetary policies to stabilize financial systems, and ultimately, economies. While it is very important that this be discussed in detail, I will refrain from doing so in my remarks today because I wish to highlight another important question regarding the design of financial systems. The “credit bubble” and its collapse we have witnessed have resulted in a growing impetus in Europe and the United States to reconsider the existing regulatory framework. In the background is the financial deregulation that made great strides after the 1990s. The United States, under the Glass-Steagall Act, maintained a clear delineation between the banking and securities businesses ever after 1933. The Glass-Steagall Act came out of the lessons learned from the Great Depression and was designed to protect depositors by separating banking business from securities business so as to improve the soundness of banks. However, in 1999, amidst a global deregulatory movement, the Gramm-Leach-Bliley Act effectively tore down the walls between banking and securities businesses. This enabled large commercial banks to enter the securities business. Meanwhile, in 2004, the Securities and Exchange Commission (SEC) relaxed the leverage restrictions on investment banks. This deregulation was of decisive importance in the current If a decision maker’s confidence is “contaminated” or eroded in the sense that she thinks, though with a small probability (say ε), she is ignorant about the situation she faces, her rational behavior can be described as “maximin” optimization. See, Nishimura, K. G., and H. Ozaki (2006), “An Axiomatic Approach to εcontamination,” Economic Theory, Vol. 27, 2006, pp. 333-340. Nishimura, K. G., and H. Ozaki (2007), “Irreversible Investment and Knightian Uncertainty,” Journal of Economic Theory, Vol. 136, pp. 668-694. Shirakawa, Masaaki (2009), "Way Out of Economic and Financial Crisis: Lessons and Policy Actions" (Speech to the Japan Society, New York), Bank of Japan, April 23, 2009. financial crisis. 9 It is said that this deregulation resulted in a sharp increase in the leverage of US investment banks from a multiple of 12 to 33. Recent years have, in addition, seen a growing role for the "shadow banking system" of financial operators outside the framework of banking regulation. Hedge funds and private equity funds epitomize the rise and fall of this shadow banking system. Able to freely engage in financial transactions without being bound by banking regulation, these financial operators used leverage to earn large profits. Investment banks can also be considered part of this shadow banking system because their regulation was looser than that imposed on commercial banks. There is nothing particularly wrong with the enlargement of shadow banking system itself if failure here does not pose a systemic risk. However, large commercial banks also developed close ties with the shadow banking system by having hedge funds under their umbrellas or by creating special purpose companies off their balance sheets to transfer related operations. It reached the point where the performance of these companies began to impact the soundness of major commercial banks themselves. In addition, the shadow banking system also had greater influence on the global financial system. When it began to face liquidity shortfalls, it accelerated the sale of its assets, bringing a downward spiral to asset prices, which in turn became one of the factors in systemic risk. The current financial crisis indicates that some form of regulation is necessary for the shadow banking system. Another important point to be raised concerns the relationship between the Basel Accord (BIS rules) and the financial crisis, specifically the procyclicality of capital adequacy requirements. When the economy improves, bank lending increases and the economy accelerates because capital requirements become smaller, corresponding with reductions in downside risk. Conversely, when the economy deteriorates, bank lending decreases and the economy decelerates because capital requirements become larger as downside risk increases. Thus, capital adequacy requirements are considered to have the effect of amplifying business cycles. 10 The procyclicality of capital adequacy requirements has been criticized for exacerbating the economic downturn in the current financial crisis. Nonetheless, it does not appear that a consensus has been reached on exactly how serious the procyclicality is. It will be important in the future that a new quantitative analysis be performed of the procyclicality to facilitate a more objective debate. 5. Re-stabilizing the financial system For the remainder of this speech, I would like to trace the recent debates from those concerning regulations to maintain the soundness of individual financial institutions to those about safety nets to maintain the stability of the entire financial system. In so doing, I will add some theoretical examinations. In reviewing the recent debate, the framework of the "3 Cs" can be of some assistance. 11 The 3 Cs stand for the words "comprehensive," "contingent" and "cost-effective." "Comprehensive" regulations are best understood as regulations without loopholes. Unless the regulatory net spans all financial institutions comprehensively, the more regulations are beefed up, the more funds will flee from strictly regulated sectors to more loosely regulated sectors. Blinder, A. S. (2009), “Six Errors on the Path to the Financial Crisis,” The New York Times, January 25, 2009. Kashyap, A. K., and J. C. Stein (2004), “Cyclical Implication of the Basel II Capital Standards,” Economic Perspectives, 1Q/2004, Federal Reserve Bank of Chicago. Rajan, R. G. (2009), “Cycle-Proof Regulation,” The Economist, April 8, 2009. "Contingent" regulations have the following properties. During the up-phase period, they should mitigate overconfidence to prevent the accumulation of systemic risks Once systemic risk actually emerges, however, they should impose few restrictions to avoid reinforcing economic deterioration. In preparation for a severe erosion of confidence, they may be furnished with some policy incentives to restore confidence. To sum up, it is desirable that regulations be contingent on risk-taking attitudes of market participants, and thus strict during booms and loose during busts. "Cost-effective" regulation is a concept which is important in the evaluation of regulations. This standard dictates that when one or more regulations could achieve the same results, the least expensive approach should be chosen. For example, if it is desirable to induce financial institutions to raise capital, it is better to do so during boom times when funding is readily available as opposed to slump times when the economy has begun to turn sour and the funding cost is higher. This standard is also important when considering how to use public funding. When making the decision between injecting capital and purchasing nonperforming credits, one must consider costs involved as well as benefits of policy effects. Currently, the Basel Committee on Banking Supervision and many other fora, interest groups and ad hoc groups are floating many different proposals about how best to regulate finance. Taking the "3 Cs" in mind, I would like to take up several regulatory reform proposals that have come out of the international debate and examine their significance. In doing so, it is perhaps easiest to divide regulations into two categories: "ex ante measures" to be taken to prevent the crisis and "ex post measures" to influence how the crisis plays out when it happens. These could also be termed "policies for normal times" and "policies for emergency times." Ex ante measures The Basel Committee on Banking Supervision is taking the lead in a discussion on ways to alleviate the procyclicality of capital adequacy requirements. As I explained, current capital adequacy requirements are considered to have procyclicality properties. In response, the discussions focus on the idea of introducing variable "buffer capital." This would make it acceptable for institutions to accumulate capital when the economy is booming and draw it down when the economy slumps. However, one can also critique this argument in terms of the "3 Cs." Capital adequacy requirements are meaningless if they do not apply to all broadly-defined financial institutions, not just banks. Even if this proposal is understood as being desirable from a qualitative standpoint, there are still many problems that would be involved in actual implementation. For example, on the idea of accumulating capital during boom times, there still is the question of specifically how much capital and at what pace it should be accumulated. And therein is the even more difficult question of how one defines and determines the business cycle. Implementation involves real-time judgments about when it is allowed to begin drawing down the buffer. However, as can be seen from the business-cycle dating problem for the Japanese economy, a long period of time is required before the peaks and troughs of the business cycle can be identified. There is also the need to clearly articulate how time lags between national business cycles will be treated. These are just a handful of issues that must be resolved before any such regulations could be fleshed out. There is another international debate taking place on liquidity monitoring. As I noted, the current financial crisis initially emerged as a liquidity crisis. At the time, the system used by regulators to monitor the liquidity of internationally-active banks was inadequate. The discussion therefore turned to ways to increase the effectiveness of international monitoring by developing common liquidity metrics and sharing information among regulators. At the current point in time, the debate focuses on which liquidity metrics would be appropriate to use. However, there are significant differences from country to country in the effectiveness of liquidity monitoring. Japan engages in detailed monitoring with the cooperation of the institutions involved, but there are some countries where the quality of monitoring is not very high. One-size-fit-all-type arguments are therefore not very realistic. Mechanisms must be sufficiently flexible and adaptable to the circumstances of individual countries. With this in mind, I would like to mention a very interesting approach to the liquidity risk. 12 Without a doubt, when the financial crisis is viewed as a liquidity crisis, the root cause is the excessive maturity mismatch on the balance sheets of funds and the like. Therefore, it would be desirable to have regulations that would provide incentives to alleviate this maturity mismatch, thereby preventing crisis. One possible solution would be to link the maturity mismatch between assets and liabilities with the capital requirement. For example, a bank raising funds from longer-term deposits would have a lower capital requirement than one raising funds in the overnight money market. This scheme would give banks an incentive to take longer maturities on the liabilities side in particular. Putting aside the question of whether it is desirable to link maturity mismatches with capital requirements, it is clear that the continuous monitoring for appropriate liquidity at financial institutions is an effective tool for detect the early-warning signs of financial crisis. The G20 meetings held in April decided to reorganize the Financial Stability Forum (FSF) as a new "Financial Stability Board" (FSB). Previously, four international institutions, the Basel Committee on Banking Supervision, International Organization of Securities Commissions, International Association of Insurance Supervisors and International Accounting Standards Board, made independent judgments and took independent actions. The FSB is expected to serve as a kind of supervisory body of these institutions and provide coordination functions. The measure aims to overcome the differences among sectors and create regulations and rules that are consistent throughout the financial system. The G20 also decided to regulate hedge funds. This is the first step in bringing the shadow banking system within the net of regulations. Ex post measures The global economy is in the midst of a financial crisis. The ex post measures that I am about to describe are the policies and programs that are actually being implemented by governments and central banks today. The United States and European countries have taken initiatives to address liquidity and fund-raising difficulties as part of steps to stabilize the financial system. These efforts can be organized into two categories: "granting government guarantees for market-based fundraising" and "expanding deposit protection." Government guarantees for market-based fundraising attempt to stabilize the market conditions for fund-raising, particularly for bond issuance by financial institutions, at a time when financial markets are increasingly strained. Most countries have also taken measures to raise deposit insurance ceiling in their deposit insurance schemes and/or to guarantee the unlimited protection of personal deposits. These measures succeed in alleviating the perceived uncertainties of depositors regarding the financial system, avoiding serious upheavals such as bank runs and providing banks with a stable source of fund-raising through deposits. During the current financial crisis, countries have responded with comprehensive policy packages. Public capital injections were an important component in those packages. However, specific nature of these injections differs from country to country and even from time to time in the same country. In some cases, injections were made across the board, even to sound banks, as a preemptive measure, while in other cases injections were to bail out financial institutions that had recorded large losses and significantly impaired their Brunnermeier, M., A. Crockett, C. Goodhart, A. Persaud and H. Shin (2009), “The Fundamental Principles of Financial Regulation,” International Centre for Monetary and Banking Studies & Centre for Economic Policy Research, Geneva Report on the World Economy, Vol. 11, 2009. capital. There are also a number of differences in the design of instruments and accompanying conditions. The United States and European countries’ governments purchase nonperforming assets and provide loss compensation schemes for these assets in order to cap loss amounts. These measures differed in terms of whether these assets were taken off balance sheets, timing when accounting losses on these assets are recognized and necessity for pricing of individual assets. Despite these differences, however, the aim was to remove concerns about the soundness of financial institutions by relieving uncertainty about their asset holdings. When Japan confronted a severe financial system problem in the late 1990s, it began by buying up nonperforming assets and later moved to injections of public capital. In contrast, the first step for the United States and European countries in dealing with the current financial crisis was to inject public capital, and then they moved on to purchasing nonperforming assets. 13 The reason for this difference, presumably, was the difficulty of valuing nonperforming assets and the speed with which the crisis was progressing. The nonperforming assets in the current crisis are complex securitized instruments, generally backed by home mortgages. With market functions significantly impaired, it is no easy task to arrive at pricing. In the United States, the public and private sectors joined together to create a fund for the purchase of nonperforming assets in an attempt to take them off balance sheets. It remains to be seen whether this system will function as intended. As the real economy worsens, the scope of nonperforming assets is moving from securitized products to commercial and other loans. A further development must be watched very closely. The impacts of the upheaval in international financial and capital markets vary across countries and regions. While the financial systems of the United States and European countries have been visibly shaken, the Japanese financial system remains stable on the whole. However, there is no guarantee that Japan will be spared a decline in financial intermediation functions because worsening earnings and falling share prices are now impinging on institutions' capital. Japan has taken a number of measures to achieve its policy goal of maintaining financial intermediation functions. On December 16, 2008, the Act on Special Measures for Strengthening Financial Functions was amended to provide for injections of public capital. On April 10, the Bank of Japan decided to provide subordinated loans to financial institutions in order to help them increase their capital. Prior to this, on February 3, it restarted a program to purchase equities from financial institutions so as to ensure the stability of the financial system by supporting to mitigate equity holding risks of financial institutions. This is a unique policy that is geared towards Japanese financial institutions, which tend to have large equity holdings. The government also restarted a purchasing program in March. 6. Approach to new safety nets Separate from the political movements to expand and strengthen regulation, there has also been a completely new approach proposed for stabilizing the financial system. What this financial crisis has clearly taught us is the extreme difficulty of strengthening banks' capital when a financial crisis is under way, that is, when macro systemic risk has materialized. Viewed from the opposite perspective, the creation of a safety net that would facilitate bank capital increases during times of crisis would greatly contribute to the stabilization of the The United States attempted unsuccessfully to introduce a scheme called "M-LEC" to purchase nonperforming assets similar to what was done in Japan. Since September 2008, it has instead opted to inject public funding, just as the European countries. financial system. The new approach that I will explain focuses on this point. I would first like to introduce the idea of private-sector "capital insurance," which is an expansion on the concept of ordinary insurance. Then, while reviewing some of the problems involved in private-sector capital insurance, I would like to discuss the potential for capital insurance in the form of a public-private partnership to overcome them. Finally, several other schemes are also introduced from a variety of schemes proposed so far. These schemes come under the general rubric of "contingent capital" in that they are safety nets that attempts to increase capital when necessary during crisis while having as little impact as possible on the market. Private sector "capital insurance" 14 Let me begin with an overview of private-sector "capital insurance." As its name suggests, this scheme involves an insurance policy. The bank has the same position as the insured in an ordinary insurance policy, while the investor has the position normally occupied by an insurance company. When an insurance policy is agreed, the bank pays the investor a premium. In response, the investor locks away liability reserves in a "lock box." Should there be a financial crisis, it pays insurance benefits to the bank from the lock box. The bank can use those funds to increase its capital. If the policy term elapses without a financial crisis, the liability reserves in the lock box return to the investor. This is the basic idea behind capital insurance. What sorts of banks are envisioned as the insured? Professor Kashyap and other advocates of private sector capital insurance say that it should be open to all financial institutions subject to the Basel Accord (BIS rules). What is crucial is that all financial institutions with the potential to cause systemic risk be enrolled, although the proponents say that it should be up to the institutions to decide whether or not to enter into an insurance policy. I would like to return to this issue in a moment and discuss it more fully, since this issue is important in determining whether this will be an effective tool for avoiding systemic risk. The next question is: Who are envisioned as insurers? Professor Kashyap and others argue that all investors not subject to the Basel Accord should be able to provide insurance. If an investor is subject to the Basel Accord, when financial crisis occurs, capital is merely transferred from one bank to another with no improvement in the soundness of the banking system as a whole. In other words, when crisis breaks out, maintaining the stability of the financial system requires the injection of capital from outside the system. According to Professor Kashyap and others, possible investors could be pension funds and sovereign wealth funds (SWF), but the problem is that there is no guarantee that these investors will invest in capital insurance. Finally, there is a question of how to identify the "insured events" that will trigger payouts of insurance benefits. The standard advocated by Professor Kashyap and other proponents is that the payout is triggered when a moving average (e.g., an average over four quarters) of the total losses of all financial institutions entering into insurance policies exceeds a certain threshold value. Their point is that it is important to look at losses for the banking system as a whole, not those for individual institutions. It reflects the fact that the capital insurance they propose is ultimately an insurance against systemic risk or financial crisis. However, putting aside clear cases such as what we find now, it can be a very difficult and subtle task to determine what constitutes a financial crisis. This is another important point that needs to be addressed from the perspective of risk management, since it relates to the questions of how quickly the scheme would be able to strengthen capital without mistakes. While the proposal of Professor Kashyap and others can seem a bit novel, it does constitute an attempt to provide a safety net for the financial system by attaching insurance so that Kashyap, A. K., R. G. Rajan and J. C. Stein (2009), “Rethinking Capital Regulation,” in: Maintaining Stability in a Changing Financial System, Federal Reserve Bank of Kansas City, pp. 431-471. capital is above a certain threshold. It is also an excellent attempt to internalize external diseconomies. During the 1990s, Japan injected enormous amounts of capital into its banks in order to stabilize its financial system. Likewise, enormous amounts of capital have been injected into European and US financial institutions during the current financial crisis. While there are some institutions that anticipate being able to repay the funds quickly, there are others that will continue to require larger and larger injections. If this capital is not returned, it will be the taxpayers that ultimately bear the costs. As I touched upon in the discussion of the "credit bubble," financial institutions engaged in excessive risk-taking under the assumption that governments and central banks would do something if there were a problem. That is, financial institutions generated the external diseconomies of systemic risk, not bearing the cost of its cleanup, but keeping all of the profits for themselves. This proposal asks institutions to bear the cost of materialized systemic risk in the form of premiums. In that sense, it internalizes external diseconomies. That being said, the proposal tabled by Professor Kashyap and others also has many problems. First, the capital insurance that they advocate is entirely private and the main insurers will be private-sector investors. Will private-sector investors on their own be able to come up with the enormous liability reserves that would be required to halt systemic risk? They look to pension funds and SWFs to play this role, but will we always rely on them? Obviously, you might be able to attract enough investors if premiums are sufficiently high. But if premiums are too high, most financial institutions would forgo insurance altogether. 15 Also, as crisis deepens, institutions may require capital injections beyond the amounts initially envisioned. There is the potential for systemic risk to materialize after all of the liability reserves have been paid out of the lock box. A crisis like the current one that is global in its dimensions may be beyond what private sector funds alone can deal with. In these situations, will it really be possible to stop the erosion of confidence? That said, this idea should be better combined with additional government-based insurance as a set to deal with large losses, and only by doing so, will it be possible to maintain confidence in capital insurance. The proposal by Professor Kashyap and others is that enrollment in capital insurance be voluntary. There is no guarantee, therefore, that all financial institutions that impact financial system stability would purchase capital insurance. This is the classic free-rider problem. In particular, a bank that considers itself "too big to fail" might very well decide not to purchase capital insurance. If it is indeed "too big to fail," then its bankruptcy would generate systemic risk and the government could be expected to bail it out regardless of whether it enrolled in capital insurance. If that assumption is correct, the bank has no incentive to purchase capital insurance. What we end up with is a situation in which no one purchases capital insurance as long as they believe that the government will never allow financial crisis to occur. There is also the question of capital insurance pricing. For ordinary insurance products, pricing is based on the law of large numbers. However, a financial crisis is a "tail event" that rarely occurs, or it is a phenomenon for which the probability distribution is completely unknown. In either case, the law of large numbers cannot be used to price capital insurance. Capital insurance as a public-private partnership As I have noted, the scheme proposed by Professor Kashyap and others has many problems. However, some of them can be solved if public institutions are used to back up private capital insurance. First, by having public institutions responsible for a part of the insurance, it is possible to provide liability reserves of sufficient size. Moreover, there is no need to actually put liability reserves away. It is sufficient for there to be a commitment to Professor Blinder made similar comments regarding the paper of Professor Kashyap et. al. at the symposium sponsored last year by the Federal Reserve Bank of Kansas City. fiscal outlays if an insured event occurs. 16 In addition, government’s involvement would prevent private premiums from becoming too high in the face of phenomena that carry large uncertainties. 17 Private sector expertise must be marshaled in order for any such insurance program to be effective. Therefore, one option that is quite possible is to create a public-private partnership in which efficient private sector institutions originate capital insurance that is, for all purposes, "re-insured" by the government. That is the form that Japan uses to provide "earthquake insurance." A public-private partnership for capital insurance enables the system to draw upon the expertise of the private sector to achieve greater efficiency than would be seen if capital insurance were provided by public institutions only. To have a well-functioning capital insurance, we need not only its public nature, but also an element of mandatory enrollment. More specifically, financial institutions with the potential to trigger systemic risk must be required to enroll in an insurance program. This solves the freerider problem. It might also allow financial institutions to opt out of the insurance program. However, in such cases, the financial institution would be required to scale back its business and demonstrate that it will not trigger systemic risk. Even still, it is no easy matter to come up with objective criteria that can be used to identify "financial institutions with the potential to trigger systemic risk." There is also a question of whether only banks need be covered by the insurance. It is impossible to foresee which business models will be the source of future instability in the financial system. Therefore, regulators must constantly review the definition of a "financial institution with the potential to trigger systemic risk" as their financial sectors develop and evolve. The remaining issue is that of pricing the insurance. The involvement of public institutions in the provision of insurance means that the burdens ultimately revert to the public. It goes without saying that it is only fair for the public to bear some of the cost because they enjoy the benefits of a stable financial system. An important issue in this will be convincing the public of the appropriateness of insurance pricing. This will require a bit of creativity in the mechanisms used to set premiums. As a rather simple example, consider a mechanism by which premiums are based on a measurement of the institution's systemic risk, defined in terms of its gross assets. In such cases, a financial institution that is right on the border between enrolling and not enrolling in insurance may elect to reduce the size of its assets so that it is not compelled to enroll. If premiums are set on the low side to encourage these financial institutions to participate, they will be too low to provide a deterrent to further risk-taking by financial institutions that carry large systemic risks. Without going into detail here, this problem can be solved with a progressive premium geared to the size of the institution. If the government is involved in insurance, it may be impossible to avoid giving the impression that this is a government-funded "bailout insurance." If that is the case, there may be new moral hazards for financial institutions. Indeed, it is not overstating the case to say that the biggest hurdle to the involvement of public institutions in capital insurance is how to suppress moral hazards. Therefore, the introduction of capital insurance with public institution involvement cannot be allowed to undermine the importance of the regulatory supervision of enrolled institutions. Rochet, J. C. (2008), “Comments on 'Rethinking Capital Regulation' by A. Kashyap, R. Rajan and J. Stein,” prepared for Federal Reserve Bank of Kansas City symposium on “Maintaining Stability in a Changing Financial System,” Jackson Hole, Wyoming, August 21-23, 2008. Nishimura, K. G. (2009), “'The Past Does Not Repeat Itself, But It Rhymes’: Four Lessons Learned from the Financial Crises,” Remarks at the Panel Session “Responding to the Financial Crises: Lessons Learned” at the 45th Annual Conference on Bank Structure and Competition sponsored by the Federal Reserve Bank of Chicago on May 8, 2009. Likewise, even if such an insurance program were to be created, it would not in any way reduce the importance of accurately communicating information on financial system stability to market participants and the general public in a manner that avoids amplifying uncertainties. The more complex the insurance program becomes, the less effective it will be in alleviating the "fear and panic" psychology of investors. For instance, if uninsured financial institutions were to fail during a financial crisis, would it be possible to maintain confidence? No one has ever tested this point, and no one can predict the outcome with any certainty. Other discussions In addition to these schemes, there have been many other proposals put forward to enable capital to be strengthened when financial institutions are in crisis, and they have served as the starting points for active discussions on how to deal with macro systemic risk. I would like to give you a brief overview of some of them. The first is an instrument called a "catastrophe bond." Most people use the abbreviated form "cat bond." The issuer of this instrument is relieved of its obligation to repay principal to investors if certain conditions are satisfied. By selling investors a bond in which redemption is waived in the event of major losses, a bank is able to maintain its capital even if losses are incurred. For example, if the bank is holding nonperforming credits, it could forgive large amounts of debts so that it could simultaneously downsize both the asset and liability sides while keeping its capital untouched. Another similar instrument is called the "reverse convertible debenture." 18 This is a bond that is automatically converted to equity if certain conditions are satisfied. Putting aside the issue of accounting treatment, this instrument has very similar effects on capital to a cat bond. By selling investors a bond that is converted to equity in the event of major losses, a bank would be able to raise its capital automatically even if losses were incurred. Finally, there is a contract known as the "margin call on shareholders." 19 This contract allows an issuer to compel shareholders to purchase additional shares when certain conditions are satisfied. For example, by issuing equity with this kind of agreement attached, a bank that incurs large losses could cause its existing shareholders to purchase new equity, reducing the need to raise capital from the market. With all of these instruments, it is possible to set the triggers differently according to specific purposes. For instance, if the objective is to maintain the soundness of a specific financial institution, the trigger would probably be the losses of that institution. If the objective is to prevent systemic risk, the trigger would be the total losses of all financial institutions enrolled in the system. In the latter case, uniform triggers would need to be set so that all contracts are fulfilled at the same time. In this section, I have tried to give you an overview of several different forms of financial instrument that could be part of a safety net for the financial system. There would need to be some form of mechanism in place for all financial institutions with the potential to trigger systemic risk to hold such instruments. Mandatory purchases are one approach, but there should also be some thought given to incentives so that financial institutions purchase them of their own accord. One effective method might be to allow institutions to count such instruments as capital. Flannery, M. J. (2005), “No Pain, No Gain? Effecting Market Discipline via 'Reverse Convertible Debentures',” Chapter 5 of Capital Adequacy beyond Basel: Banking, Securities, and Insurance, edited by Hal S. Scott, Oxford University Press, 2005. Hart, O., and L. Zingales (2009), “To Regulate Finance, Try http://experts.foreignpolicy.com/posts/2009/03/30/to_regulate_finance_try_the_market. the Market,” in 7. Conclusions There is a growing momentum, particularly in Europe, for stronger bank regulation. The argument is based on the opinion that the current global financial crisis would not have occurred if regulation had been sufficiently strong. However, one must question whether stronger regulation by itself will prevent future financial crises. There has been no demonstration on this point, and indeed, it has not even been fully discussed, even in academic circles. There is an undeniable impression that most of the debate on banking regulation in recent months has accepted the assumption that stronger regulation is necessary to prevent the recurrence of crisis without any critical investigation. There should also be a careful and cautious discussion of the side effects from more regulation. If one takes a step back to the fundamental economic perspective of government involvement versus economic efficiency, there are two trade-offs in particular that could be considered to be of importance. The first is the relationship between improved financial intermediation functions and financial system stability. Stronger regulation may indeed increase the stability of the financial system. On the other hand, government interference has the potential to reduce economic efficiency. Inefficiency in the financial services sector manifests itself in the form of reduced financial intermediation functions. These questions can be viewed as issues of public economics and the tools of this discipline need to be applied to a cost-benefit analysis from the two perspectives of quality and quantity. Such an analysis should be applied to a wide range of candidate regulations in order to arrive at the best balance between economic efficiency and government regulation and interference. The second point to consider is the trade-off between financial sector innovation and financial system stability. When unease in the financial system surfaces, there is always an argument about restricting the operations that financial institutions can undertake, as manifested by “narrow banking” approaches. However, in many cases, this argument is lack of a perspective of financial innovation. It would be very difficult indeed to enhance value added in the finance industry without using innovation to flexibly adapt to dynamic economic developments. We must therefore consider approaches to promoting innovation while also maintaining the stability of the system. In doing so, we must pay attention to the two forms of innovation: One is achieved by the consolidation and attrition of companies and the other is achieved within a single company. Japan has a large number of "long-established" companies, a fact that illustrates the process of innovation in the latter sense that has taken place again and again over time. Financial sector is no exception: Innovation occurs primarily within banks. Therefore, promoting innovation in the financial sector can be seen as a question of promoting a "scrap and build process" within organizations as the environment changes. The current global financial crisis raises significant issues for financial institution risk management and supervisory regulation. In my remarks today, I have described some of the very active debates that are currently taking place. Japan experienced the rupture of an asset bubble in the early 1990s and a prolonged period of financial and economic stagnation thereafter. We therefore have the advantage of being able to discuss issues realistically on the basis of our experiences. I look forward to greater contributions to the debate from the Japanese academic community, and with that hope I would like to close my remarks today. Thank you for your kind attention.
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bank of japan
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Remarks by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Eighth Bank for International Settlements, Annual Conference, Basel, 26 June 2009.
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Masaaki Shirakawa: Some thoughts on incentives at micro- and macrolevel for crisis prevention Remarks by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Eighth Bank for International Settlements, Annual Conference, Basel, 26 June 2009. * * * Introduction The current financial and economic crisis has posed wide-ranging challenges to policymakers and academics. Already, various proposals have been made for the reform of financial supervision and regulation. The traditional approach in this area is based on a microprudential perspective. From that perspective, financial system stability will be achieved by assembling sound financial institutions with adequate capital and liquidity positions as well as proper risk management. That approach certainly plays an important role, but I am still uncertain whether the cumulative efforts in that approach will eventually ensure the financial system being shielded from a future crisis. In fact, the financial regulatory and supervisory framework was reformulated from the microprudential viewpoints every time a financial crisis occurred. In that respect, I will raise two questions. The first question is: “Has legally effective netting contributed to reducing the overall degree of risk in the financial system?” It is true that netting is effective in reducing counterparty risk. However, once the risk is reduced to a certain degree, a financial institution tends to take further risk. As a result, it is still not certain whether netting contributes to reducing aggregate risk. The second question is: “Will a financial institution take a different business strategy not to expand its leverage when facing again a benign economic condition, comprised of low inflation, high growth, and low interest rates?” Some financial institutions will surely take a conservative strategy, considering the lessons from the current crisis. But, most financial institutions will find it hard to resist pressures from equity holders to raise the returns on equity under severe competition. Those examples seem to show the need for analyzing the incentives of financial institutions from the viewpoints of the macro- as well as micro-level. Incentives for a financial institution are underpinned not only by the framework for financial regulation and supervision at a micro level but also importantly by the financial and economic environment at a macro level. At a micro level, “too big to fail” is the single most important issue. At a macro level, monetary policy is important. Today, I will mainly focus on monetary policy responses to a bubble. Then, I will briefly touch upon some issues on supervision and regulation. Importance of risk-taking channel Before the current global financial crisis, the majority view about the monetary policy responses to a bubble can be summarized into two points. First, before the burst of a bubble, monetary policy should respond to asset price movements, whether driven by the fundamentals or not, only to the degree that those movements have implications for future inflation and economic growth. Monetary policy should not go beyond that or should not step into “extra operations,” by which I mean a policy decision to intentionally deviate from a monetary policy rule, like the Taylor rule. Second, in contrast to the bubble period, central banks should be proactive after the burst of a bubble. Monetary policy should carry out “mopup operations” aggressively responding to the adverse effects stemming from the burst of a bubble. This line of argument is generally premised on the assumption that a bubble is very difficult to be identified on a real time basis, and that a preemptive action by monetary policy alone is likely to require a large hike in interest rates, thus exerting a devastating adverse impact on economic activity. To discuss the monetary policy responses to a bubble, it matters a great deal how to understand the transmission mechanism of monetary policy. The recent monetary policy analysis, based on new Keynesian macroeconomics, explores optimal monetary policy to stabilize inflation and output. The declines in volatility of inflation and economic growth themselves certainly improve the economic welfare, but dynamics in the economy do not stop there. Once macroeconomic stability is achieved, another transmission channel outside the standard New Keynesian macroeconomics gets crucial. That is often referred to as the “risk-taking channel” of monetary policy. More precisely, risk perception and risk tolerance of economic agents change gradually but steadily under benign economic and financial conditions, thereby affecting their risk-taking behavior. That induces an expansion of credit and leverage at financial institutions, and results in the accumulation of financial imbalances behind the scenes. Such imbalances abruptly manifest themselves by some shock when the imbalances exceed the critical point. As a result, the financial system becomes unstable, and economic activity deteriorates significantly. We see various forms of risk-taking channel. First, it appears as maturity mismatches. When the interest rates are reduced, financial institutions expand maturity mismatches by shortterm funding and long-term lending. That eases liquidity constraints in the non-financial private sector, thereby stimulating economic activity. Financial institutions also create maturity mismatches on their off-the-balance-sheet, for example, by investing in structured credit products through structured investment vehicles (SIVs). In addition, financial institutions generate maturity mismatches beyond the national border, as witnessed in the surge in cross-border lending during the credit boom preceding the current crisis. Second, the risk-taking channel appears as an increase in asset prices. The availability of funds directly influences asset prices, and, more importantly, it also influences asset prices in an indirect way by influencing market liquidity of particular assets. As the availability of funds improves and more investors participate into the markets, the market transactions become easier in both sale and purchase, thus expanding market liquidity at an accelerated pace. The increases in asset prices and the expansion in market liquidity enhance the risk tolerance capacity of investors, thereby pushing asset prices further upward. Economic activity is consequentially stimulated. In addition, the two forms of risk-taking channel just I mentioned interact with each other. The expansion of maturity mismatches, generally associated with the expansion of leverage, stimulates asset prices, and higher asset prices, in turn, facilitate the expansion of maturity mismatches and leverage. Considering the risk-taking channel, it is crucially important to realize two points in formulating monetary policy. First, banks play an important role as a mediator of transmitting the effects of monetary policy. In this context, the behavior of banks influences the economy significantly, regardless of the share of the banking sector in financial intermediation. During a period of interest rate reduction, for example, expansions in maturity mismatches and increases in asset prices are observed on a bank’s balance sheet. When the cycle is moving upward under benign economic and financial conditions, the amplification process between maturity mismatches and asset prices takes place very gradually but steadily, and, in any case, the risks in the financial system are unlikely to manifest themselves. Once the cycle is reversed, however, the situation deteriorates suddenly. Maturity mismatches exaggerate the shortage in funding liquidity. In addition, the sharp declines in asset prices result in losses, possibly inducing a shortage in capital, and the deterioration in market liquidity, thereby provoking a further shortage in funding liquidity due to margin calls and lowered collateral values. Those developments eventually hit banks’ balance sheets. Second, there exists an asymmetry between the upward and downward phases. Although the upward phase proceeds gradually, the downward phase proceeds in an asymmetrically quick manner, since banks are forced to take immediate action to counter the shortage in funding liquidity. In addition, once confidence is lost, it takes a long time to restore the eroded confidence. As market participants explain, the credit line can be cut off at once, but the reestablishment of the credit line takes a much longer time. Issues related to monetary policy Mop-up operations Given the understanding on the risk-taking channel I have discussed so far, what consequences will follow from the asymmetric monetary policy responses before and after the burst of a bubble? Suppose a central bank is considered to make a commitment to refrain from taking any monetary policy responses until the burst of a bubble, the private agents will surely take action based on such unfounded expectations. That will accelerate maturity mismatches and asset price increases, thus further accelerating the bubble and the adverse consequences of its burst. One of the basic messages from standard New Keynesian macroeconomics is that “the policy commitment is effective in stabilizing the economy, given the forward-looking behavior in the private sector.” Standard New Keynesian macroeconomics does not incorporate the risk-taking channel, but its basic message suggests the importance of the symmetric monetary policy responses to a bubble. Extra operations Then, what is an idea about extra operations against a bubble? I agree with the principle that monetary policy should respond to asset price movements, whether driven by the fundamentals or not, only to the degree that those movements have implications for future inflation and economic growth. I should also say that the real issue here is how to understand the expression of “only to the degree that asset price movements have implications for future inflation and economic growth” in implementing monetary policy. The transmission dynamics of the risk-taking channel, I have just mentioned, differs significantly from those of the standard interest rate channel through housing investment and capital investment. The risk-taking channel produces asymmetric effects between the initial positive impact and the later negative impact. And, more importantly, it also accompanies considerable uncertainty about the timing when negative impacts occur. Given such nature of the risk-taking channel, conventional macroeconomic models in a central bank’s toolkit do not sufficiently incorporate the effects stemming from maturity mismatches and asset prices in the short term as well as in the longer term. Policy challenges for central banks In light of the previous discussion, I will raise some issues for discussion regarding the actions by central banks. Monetary policy responses to a bubble The first is monetary policy responses to a bubble. That issue is often debated simply as whether monetary policy should lean against the wind or excessive asset price increases. However, I believe that such a way of addressing the issue just confuses the discussion. No central banker believes that a bubble can or should be prevented by monetary policy alone. A more proper way of addressing the issue would be “how should monetary policy be conducted in an environment in which all the symptoms of the economy except for inflation signal a need for policy tightening: asset prices are rising, credit and leverage are increasing, maturity mismatch is widening, and the economy is being overheated, while only inflation remains low and stable?” My answer is that monetary policy responses are needed anyway, and it is just semantic whether to call them extra operations. I should hasten to add that the build-up of excesses, of course, cannot be contained by monetary policy alone, and needs to be addressed by a combination of policy measures. That leads me to the second issue of the role of policy measures other than monetary policy. Two objectives and two instruments? It is often argued that achieving the two objectives, price stability and financial system stability, requires two policy instruments. Active discussions are continuing regarding the need for developing prudential policy measures, including the countercyclical implementation of minimum capital adequacy requirements. I completely agree with the necessity of developing prudential policy measures. Having said that, I am wondering whether it is valid to employ the Tinbergen principle in this context. The two objectives are not independent but closely connected with each other. It does appear that an intra-temporal trade-off exists between current price stability and current financial system stability. However, a real trade-off does exist in an inter-temporal direction between the current economic stability and the future economic stability. If that is the case, financial system stability and price stability are not independent objectives, but just differ in the time-horizon. I should say that central banks need one large toolkit to achieve one large policy objective, rather than need two policy instruments for the two objectives. Versatility of regulation The third is regulatory and supervisory issues at a micro level. Among various issues for discussion, I will focus on the versatility of the regulation to fit a variety of financial institutions. On the one hand, heterogeneity in financial institutions is quite important in enhancing the robustness of the financial system against shocks. On the other hand, onesize-fits-all treatments of heterogeneous financial institutions in designing prudential regulation, such as capital adequacy regulation and liquidity regulation, entail a risk of deteriorating the robustness of the financial system. If regulatory capital is set at the level above economic capital, pressures on financial institutions from equity holders to earn sufficient profits become all the more intense. As financial history tells, too much as well as too little capital has caused problems. That is, excess capital is likely to induce a pile-up of financial imbalances. If a risk measurement framework is inappropriate, and minimum capital requirements based on such a risk measurement framework are excessively high, that will produce perverse incentives for individual financial institutions, resulting in a trigger for macroeconomic instability. Capital and liquidity positions for financial institutions depend crucially on the business model. A business model for financial institutions varies according to countries, or times, institutions. The issue here is the ability of regulatory authorities to assess the business model. Given differences in business model, redesigning capital adequacy regulations is an important challenge, along with the conduct of monetary policy. Closing remarks In closing, I ask myself what are the determinants of the amount of economy-wide risk-taking after all. There is no simple answer. Yet, I believe both micro and macro approaches are needed for preventing a future crisis.
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bank of japan
| 2,009 | 7 |
Speech by Mr Hirohide Yamaguchi, Deputy Governor of the Bank of Japan, at a meeting with business leaders, Hakodate, 22 July 2009.
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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, Hakodate, 22 July 2009. * * * Introduction I am honored to have this opportunity to speak today before business leaders in Hakodate and the Donan area. I would like to express my gratitude for your cooperation in interviews with staff from the Hakodate Branch and in the Bank of Japan's surveys. Information obtained from these interviews and surveys is very valuable and utilized fully in appropriately assessing economic and financial developments and conducting monetary policy. Hakodate is a city that opened the door to modernization and internationalization by becoming one of the first ports in Japan to engage in international trade. It has played an extremely important role in Hokkaido's economy as well as that of Japan as a whole. The Bank established a local office in Hakodate in 1893, which is now the Hakodate Branch, the second oldest of the existing branches after the Osaka Branch. This was two years before the establishment of the Hakodate Chamber of Commerce and Industry. I believe that the fact that the Hakodate Branch has been able to continue its central banking operations here for more than a century owes much to the understanding of and support from the business community as well as the people of the area in general. About ten years after the opening of the Bank's local office in Hakodate, a man named Ryokichi Kawada came to Hakodate to serve as the executive of a local shipbuilding company. He worked at the company while establishing a farm in the town that is now called Nanae. He began growing Irish potatoes, which are suitable for cultivation in Hokkaido's climate, and devoted his life to increasing their popularity. Since he held the title of baron (danshaku), which he had received from his father, the potatoes were named danshaku potatoes, and they have since become one of Hokkaido's well-known products. You may well be familiar with this story, but I think it is less well known today that his father was Koichiro Kawada, the third Governor of the Bank, who established the local office in Hakodate. I was very interested to learn of this connection between the Bank and Hakodate. Before exchanging views with you, I would like to talk about the current state of and outlook for Japan's economy, and explain how the Bank has been conducting monetary policy to deal with the severe economic conditions since last autumn. I. Economic and financial developments in Japan A. The current state of Japan's economy I would like to talk first about the current state of Japan's economy. The deterioration of economic conditions in Japan that began last autumn was so sharp and substantial that it was described as "falling off a cliff." Fortunately, economic conditions have recently begun to stop worsening. The Bank holds Monetary Policy Meetings (MPMs) every month, where the Policy Board members, at present eight including the Governor, discuss economic and financial developments, and decide on the guideline for monetary policy conduct for the immediate future. At the July meeting held last week, the Bank judged that Japan's economic conditions have stopped worsening. Let me elaborate somewhat on the background to this assessment. The main factor that has caused economic conditions to stop worsening is the recovery in exports and production, especially of automobiles and electrical machinery. Exports and production of automobiles are showing a clearer recovery trend due mainly to progress in adjustments of inventories, especially those held abroad. More firms have recently started to increase their production, especially of hybrid cars, reflecting a measure to promote the purchase of new automobiles introduced in April 2009. Orders for electronic parts from overseas have increased sharply since the beginning of this spring against the background of progress in inventory adjustments both at home and abroad and measures to stimulate domestic demand being taken in China, and thus their production has picked up. There has been a particularly large improvement in orders for parts used in flat-panel televisions, cellular phones, and personal computers. Production of not only electronic parts but also finished goods, particularly flat-panel televisions, has recently increased. Some expect production to be on a relatively steady growth path due mainly to a boost to sales from the "eco-point system" – whereby consumers who buy eco-friendly electrical appliances are given points that can be exchanged for other goods. I am informed by the Hakodate Branch that capacity utilization has begun to rise among manufacturers of electronic parts in Hakodate, who had to reduce their production substantially some time ago. Public investment is also increasing, reflecting the implementation of the economic policy package since the previous fiscal year. The value of public works contracted started to rise year on year in the January-March quarter of 2009, and recorded an increase of more than 10 percent in April-May. The value of public works contracted in the Donan area has recently picked up as well. On the other hand, domestic private demand, namely, business fixed investment and private consumption, has continued to weaken amid persisting sluggishness in corporate profits and the worsening employment and income situation. Looking at the June Tankan (Short-Term Economic Survey of Enterprises in Japan) released earlier this month, firms' fixed investment plans for fiscal 2009 decreased by almost 20 percent year on year. Regarding private consumption, sales of electrical appliances have increased and the number of new passenger-car registrations has recently picked up. However, sales at department stores and supermarkets have continued to be on a declining trend. Outlays for travel have also continued to decline. As these developments show, a sharp drop in exports since last autumn and the subsequent decrease in production have started to adversely affect domestic private demand with a lag. At present, a recovery in exports and production and the weakness in business fixed investment and private consumption seem to be in a tug of war. B. The outlook for Japan's economy I would now like to move on to the outlook for Japan's economy. As I mentioned earlier, there are currently both upward and downward pressures in Japan's economy. Regarding which will prevail, the Bank's baseline scenario projects that the upward pressure will outweigh the downward, leading the economy to start recovering from the latter half of fiscal 2009. Global financial markets are expected to regain stability and overseas economies to start to recover, and in Japan the aggressive fiscal and monetary policy measures are likely to have positive effects. In addition to an increase in exports, business fixed investment and private consumption are therefore expected to be on a gradual recovery path. Stock prices have continued to fluctuate, but appear to have picked up from the sluggishness observed some time ago. The Nikkei 225 Stock Average has recently been around 9,500 yen, up by more than 30 percent compared with early March when it recorded the lowest level since the bursting of the bubble. According to the Economic Watchers Survey and Consumer Confidence Survey, the pessimism of firms and households regarding economic conditions has subsided since this spring. The June Tankan also showed that business sentiment, especially of manufacturing firms, has stopped deteriorating. These survey results seem to basically reflect recent signs of a leveling out of the economy and expectations of positive effects from various policy measures. Nevertheless, the question whether the degree of improvement in the sentiment of the market and the public is consistent with the capability of Japan's economy to recover – in other words, the strength and sustainability of Japan's economic recovery – warrants further examination. I have outlined developments in exports and production to show that economic conditions have recently stopped deteriorating, and now I would like to talk about factors underlying these developments. There are three main factors. First, inventory adjustments are proceeding at a relatively rapid pace both at home and abroad. Second, a variety of aggressive fiscal and monetary policy measures and measures to stabilize financial systems are being implemented around the globe. And third, extreme concerns about the economic outlook are beginning to subside. However, obviously, none of these factors will guarantee continuous and autonomous economic recovery, in other words, a recovery in private final demand. For instance, large-scale fiscal policy measures can temporarily mitigate the economic downturn, but cannot be relied on forever. The recovery path of Japan's economy depends greatly on whether private final demand – exports, consumption, and business fixed investment – recovers strongly in a sustainable manner without any help from fiscal and other policy measures after the completion of current inventory adjustments. On this point, I believe that at present there is still significant uncertainty for the following reasons. The first is that future developments in Japan's final demand will be greatly influenced by overseas economic conditions. Since the emergence of the subprime mortgage problem in the summer of 2007, the financial positions of U.S. and European financial institutions have deteriorated significantly due mainly to a fall in the prices of securitized products, and these institutions are still in the process of disposing of impaired assets. Under the circumstances, if the sluggishness in corporate profits is protracted or if asset prices continue to decline, the capital strength of financial institutions may be reduced further and their lending attitudes may become more cautious, thereby leading to a further deterioration in overseas economic conditions. This phenomenon is described as an "adverse feedback loop operating between financial and economic activity," in which financial and economic activity adversely influence each other to bring about a spiraling economic downturn. Since last year, the adverse feedback loop has become a major problem especially in the United States and Europe. If this phenomenon intensifies again in overseas economies, exports may decline and thereby adversely affect Japan's economic activity. I will explain the adverse feedback loop in detail later in my remarks. The second reason is that it is uncertain to what extent a change in firms' medium- to longterm growth expectations will affect the economy – in other words, how firms' outlook for the economy will change and how this will influence business fixed investment and ultimately private consumption. If the recovery in overseas economies is delayed or overseas economic conditions deteriorate unexpectedly, firms may become more cautious about the future economic outlook. In that case, given that firms draw up business and personnel recruitment/reduction plans based on their economic outlook, business fixed investment may decrease further and private consumption may remain sluggish due to a worsening employment situation. There are several other factors that increase the uncertainty about the economic outlook, and there is in fact a possibility that economic conditions may improve more than expected. The Bank's assessment, however, is that the downside risks to the economy, especially those that I mentioned earlier, warrant particular attention. The Bank will continue to carefully examine overall economic activity, including these risks, at each MPM. C. Price developments I have talked so far mainly about economic activity, and would like to turn now to developments in prices. All of you may recall the surge in the prices of crude oil and crops through the summer of 2008. At that time, the year-on-year rate of change in the consumer price index (CPI) for all items excluding fresh food recorded an increase of around 2.5 percent. This was the highest rate in the 16 years since June 1992, if we exclude the effect of a change in the rate of consumption tax. However, it began to moderate in the autumn reflecting the declines in the prices of petroleum products and the stabilization of food prices, and has recently turned negative. The year-on-year rate of decline in the CPI will likely accelerate for the time being, partly due to the price rise observed last year, but is expected to moderate from the latter half of fiscal 2009 through fiscal 2010 against the backdrop of a moderate recovery of economic activity. Price stability is conceptually a state where various economic agents including firms and households can make decisions regarding economic activity such as investment and consumption without being concerned about fluctuations in the level of prices. The level of price changes that firms and households usually presuppose when making their decisions is therefore important. This level is influenced greatly by past experiences – that is, the level of price increases which firms and households have actually experienced in the past. In Japan, inflation has been markedly low over the past several decades relative to other major countries. For example, the average year-on-year rate of increase in the CPI since 1985 is 0.7 percent, while it is around 3 percent in the United States and the United Kingdom. Taking into account factors such as the record of low inflation, the level of inflation that each member of the Policy Board currently understands as being consistent with price stability over the medium to long term is "a year-on-year rate of increase in the CPI falling in a range approximately between 0 to 2 percent, with most members' median figures at around 1 percent." Some of you might question how the projection that the CPI will remain negative for the time being should be understood against the Bank's understanding of price stability I just mentioned. On this point, I would first like to emphasize that price stability is a medium- to long-term concept. When the economy is hit by a significant shock as at present, large shortterm swings in the actual rate of price change cannot be avoided. What I would like to stress here is that the Bank believes that preventing price declines from leading the economy into a deflationary spiral is most important. A deflationary spiral is a vicious circle in which price declines lead to deterioration in economic conditions, and this in turn causes further price declines. As I mentioned earlier, the Bank's baseline scenario projects that the rate of decline in prices will accelerate temporarily, but will moderate from the latter half of fiscal 2009 against the backdrop of a recovery of economic activity. The Bank therefore thinks it unlikely at present that prices will continue to decline and thereby lead Japan's economy into a deflationary spiral. D. Developments in corporate financing Next, I would like to talk about recent developments in corporate financing. The Bank's current assessment of financial conditions is that, while remaining generally tight, they have continued to show signs of improvement. Immediately after the failure of Lehman Brothers, raising funds from the CP and corporate bond markets became extremely difficult and interest rates rose sharply. However, issuing conditions for CP and corporate bonds have improved steadily: the issuing rates on CP and corporate bonds have declined significantly; and the number of firms issuing corporate bonds has been increasing. Funding conditions have been on a recovery trend, especially among large firms, because the increase in demand for working capital has receded against the backdrop of the recent reduction of inventories and also because firms' demand for additional liquidity observed since last autumn has stopped increasing. In the case of small firms, the emergency guarantee scheme implemented by the government has been underpinning their funding conditions. In fact, various surveys including the June Tankan show that both large and small firms see their financial positions and lending attitudes of financial institutions as having improved slightly. On the other hand, issuance of corporate bonds by firms with low credit ratings has remained subdued. Moreover, a large number of firms have continued to see their financial positions as weak and lending attitudes of financial institutions as severe, although firms' financial situation in these regards has begun to improve slightly. With regard to future developments in corporate financing, there is uncertainty about whether these signs of improvement will become widespread. The financial positions of Japanese financial institutions remained relatively stable even after the emergence of the subprime mortgage problem. Unlike in the United States and Europe, failures of financial institutions have not occurred in Japan. Nevertheless, the financial statements of financial institutions for fiscal 2008 showed net losses for the first time in five years for major and regional banks and in six years for shinkin banks, mainly due to a decline in net operating profits and an increase in losses on securities. Although the outcome depends on future developments in economic activity as well as in corporate profits, we cannot rule out the possibility that the assessment of firms' credibility by financial institutions and market participants may become more severe. In that case, lending attitudes of financial institutions might become more cautious, and conditions for corporate financing might not recover fully. The Bank will therefore continue to examine developments in corporate financing, with the assistance of our branch network. II. Adverse feedback loop operating between financial and economic activity If you will bear with me, let me take a moment to explain in more detail the phrase "adverse feedback loop operating between financial and economic activity," which I mentioned earlier. Although it may sound unfamiliar, it is a key phrase for understanding the current global economic downturn and in making economic forecasts. In the explanation that follows, for the sake of clarity, I will substitute "financial institutions" for "financial activity" and "economic conditions" for "economic activity." Financial institutions must comply with many regulations, including the Banking Act, to ensure their soundness. This is because they have a financial intermediation function to provide firms and households with funds that have been entrusted to them by depositors. One of these regulations requires financial institutions to hold capital above a certain level that corresponds to the total amount of risk they take, for example, the probability of failures among the firms they lend to. To put it another way, financial institutions cannot take risks exceeding a certain level that is calculated based on the amount of capital they hold. Given that no firm is guaranteed never to fail, some degree of risk is always attached to loans that financial institutions extend to firms. They are required to control the amount they lend so that the total amount of risk they take does not exceed the level permitted. If a bank's capital decreases as a result of it incurring a large amount of losses due to a decline in stock prices or a failure of a firm it has lent to, the total amount of risk the bank can take will decrease accordingly. In this case, the bank will become more cautious than before in extending loans that are accompanied by risk. From the standpoint of firms, loans will become less available. Should this lead to a reduction in business operations at a large number of firms, overall economic conditions will deteriorate in consequence. Some of these firms may go bankrupt due to a deterioration in their business conditions. If this occurs, banks' capital will decrease further due to resolution of the losses incurred through the failures of the firms the banks lent to. This will lead to a further tightening in banks' lending attitudes and bring about further failures and deterioration in economic conditions. Thus, tighter lending attitudes resulting from decreases in capital lead to a deterioration in economic conditions, and this in turn brings about a further deterioration in economic conditions through further decreases in capital and tightening in lending attitudes. This vicious circle is the phenomenon described by the phrase "adverse feedback loop operating between financial and economic activity." In addition to bank loans, which I have just used as an example, firms, especially large ones, sometimes acquire funds in the CP and corporate bond markets. In addition, in the case of small to medium-sized firms, they sometimes acquire funds from business partners and parent companies – so-called trade credits. Investors that provide funds in the CP and corporate bond markets and firms that provide trade credits to other firms also cannot take excessive risks in order to maintain their financial soundness. In other words, an adverse feedback loop may be initiated not only through bank loans, but also through practically every channel of financial activity, including financial markets and trade credits. The current world economic downturn is to a considerable extent due to the adverse feedback loop operating between financial and economic activity. Financial institutions in the United States and Western Europe, already faced with a substantial deterioration in their financial positions after the emergence of the subprime mortgage problem, became even more risk averse as a result of the financial market turmoil caused by the failure of Lehman Brothers. In some countries, especially in the United States, an adverse feedback loop intensified, with the effects of a decline in real estate prices and increases in delinquencies of consumer loans reflecting the deterioration in economic conditions becoming additional factors. Furthermore, the adverse feedback loop has spread across borders and oceans to become a global phenomenon because, for the last several years, large financial institutions and investors in the United States and Western Europe have been assuming a role in intermediating funds to emerging economies, in Central and Eastern Europe and Latin America for example. As these consequences show, the impact of the adverse feedback loop on the economy is extremely large. In addition, the adverse feedback loop is compounded by the following complex issues that make it very difficult for policymakers to deal with. The first issue is that an adverse feedback loop can intensify suddenly without clear forewarning. It is therefore difficult to anticipate, and required policy responses are likely to be delayed. Even if losses incurred by financial institutions expand due to the declines in stock prices and failure of firms they lend to, the financial intermediation function of financial institutions will not immediately be impaired as long as they hold sufficient capital to absorb these losses. The risk-taking capability of financial institutions will gradually decline, but at this stage, the situation will remain, so to speak, a "touch of fever" as in a cold, since ample physical strength, measured by the amount of capital, remains. However, when the amount of losses relative to capital reaches a certain critical point, financial institutions will become very sensitive to their lack of capital and may become acutely cautious in taking risks. It is like the persistence of fever bringing about a decline in physical strength that suddenly causes the sickness to take a turn for the worse. If an economic downturn should cause such symptoms to prevail among financial institutions, an adverse feedback loop will intensify rapidly. Policymakers including central banks need to keep a close eye, from an early stage, on how economic developments are affecting the physical strength and financial positions of financial institutions, namely, their capital and lending attitudes, through frequent exchange of information with the financial institutions and market participants. The second issue is that once an "adverse feedback loop" starts to intensify, it becomes extremely difficult to stop. When financial and economic activity falls into a vicious circle, attending to only one side of the problem will not provide a real solution. A comprehensive policy response is required. For example, reductions in interest rates and increases in public spending, both to stimulate the economy, will become necessary in addition to measures to restore stability in the financial system, such as the bolstering of financial institutions' capital bases and the disposal of impaired assets. In Japan, the "adverse feedback loop" was not grasped as a dire issue for some time after the bubble burst in the early 1990s. However, the financial strength of financial institutions was gradually undermined during this period, and there was a sudden intensification of an adverse feedback loop in the latter half of the 1990s. Belatedly at that point, public funds were injected into financial institutions for the first time. The first injection, however, was not sufficient to dampen the "adverse feedback loop," and a number of additional measures and years were required thereafter for the financial intermediation function and economic conditions to recover fully. Never forgetting this bitter experience, we should take every opportunity to share this lesson with policymakers abroad. In the current downturn, voices warning about an intensification of the adverse feedback loop were also frequently heard when Japan experienced a sharp decline in stock prices this spring. Fortunately, however, the situation so far has not advanced to that stage despite the significant deterioration in economic conditions. One reason for this may be the fact that the financial condition of Japan's financial institutions remains relatively stable. In addition, the government's emergency guarantee scheme that takes on a portion of credit risks in place of private financial institutions and a framework established by the revision of law in December 2008 to enable injection of public funds into financial institutions seem to be contributing to forestall an intensification of the adverse feedback loop. Furthermore, the Bank has introduced measures such as purchases of stocks held by banks and provision of subordinated loans to banks. The measures we have taken are aimed at providing financial institutions with means to secure necessary capital even if they become concerned about increases in credit risks and a fall in stock prices, thereby ensuring smooth functioning of financial intermediation. In the United States and Europe, various policy actions have also been taken in quick succession since last autumn by central banks and governments faced with a rapidly developing large-scale adverse feedback loop. In the United States, measures to restore stability in the financial system, such as an injection of public funds and purchases of impaired assets, and large-scale fiscal measures, totaling around 75 trillion yen, are being implemented. The Federal Reserve has also introduced various aggressive monetary easing measures, including reductions in its policy interest rate. Although the situation remains fragile given the continued declines in the prices of residential and commercial properties, it is hoped that the adverse feedback loop will gradually be mitigated with the help of these policy actions. Let me point out another issue regarding the relationship between financial and economic activity. What I have discussed so far is declining financial and economic activity in the phase of an economic downturn. In the phase of an economic expansion, the opposite phenomenon may occur. For example, if capital increases due to an accumulation of profits reflecting an economic expansion, the risk-taking capability of financial institutions will increase. And if this induces financial institutions to adopt aggressive lending attitudes, economic conditions will be boosted further. Thus, changes in the capital of financial institutions are a factor amplifying business cycles both upward and downward through changes in their lending attitudes. Given the experience of both the current sharp economic downturn and the overheating of the world economy that preceded it, a wide range of issues, including the degree to which financial institutions should be regulated, are being hotly debated internationally to moderate the amplification of business cycles. III. The Bank's conduct of monetary policy I have so far explained the situation of Japan's economy and its prospects with some reference to economic developments overseas. I will turn now to the subject of recent policy conduct by the Bank, some aspects of which I have already mentioned. Since last autumn, the Bank has taken a number of measures in view of the substantial deterioration in economic conditions and tight financial conditions. I will refer here only to the most important ones. First, there have been policy interest rate reductions. The Bank has reduced its target for the policy interest rate – the uncollateralized overnight call rate – from 0.5 percent to 0.1 percent. Reduction of the policy interest rate is the most conventional policy action taken by central banks to increase demand in the economy. Usually, when central banks alter their policy interest rates, it is assumed that this will influence longer-term interest rates in financial markets and firms' funding rates. If, however, financial markets are unstable or financial institutions and investors become excessively cautious in taking risks, financial intermediation will not function properly, and the effects of the reduction in the policy interest rate will not spread to the whole economy as intended. The turmoil in the U.S. and European financial markets that stemmed from the failure of Lehman Brothers has had various negative effects on Japanese financial markets since last autumn. In the money market, where financial institutions exchange funds with each other, interest rates remained elevated due to an increase in funding pressures. In the CP and corporate bond markets, providers of funds practically disappeared, and this has led to a tightening in overall corporate financing. Faced with this situation, the Bank introduced a number of additional measures in order to ensure that the effects of reduction in the policy interest rate were fully felt in the economy. One of the additional measures is the aggressive provision of funds to ensure stability in the money market. Specifically, the range of collateral that financial institutions can submit to the Bank to borrow funds has been expanded and the amount of Japanese government bonds that the Bank purchases from financial institutions has been increased. The Bank thinks that, if financial markets stabilize as a result of the Bank providing sufficient liquidity to financial institutions, the positive effects of the decline in interest rates will spread more smoothly and corporate funding will be made more secure. Another is measures to facilitate corporate financing. In view of the sharp decline in transactions and a substantial rise in interest rates in the CP and corporate bond markets, the Bank introduced a scheme to purchase CP and corporate bonds from financial institutions. In addition, the Bank introduced a scheme to provide financial institutions with unlimited funds against the value of collateral, such as CP, corporate bonds, and loans on deeds, at a low interest rate. Owing partly to these measures, corporate funding conditions have improved as can be seen in reactivation of transactions and the decline in interest rates in the CP and corporate bond markets. These measures, however, are not exclusively favoring large firms issuing CP and corporate bonds. If funding conditions of large firms improve, the positive effects of the policy actions will spread to small to medium-sized firms through improvements such as an easing of conditions of trade credits in terms of interest rate and maturity. These measures to facilitate corporate financing, while they have been introduced as necessary measures in view of financial and economic conditions in Japan, are highly exceptional for a central bank. Outright purchases CP and corporate bonds inevitably involve the Bank taking on credit risks of individual firms. They may, therefore, exert negative effects on the Bank's balance sheet, which forms the basis for confidence in the money the Bank provides. In addition, if the Bank should intervene excessively in a particular market, there is a concern that it might distort market functioning, whereby funds are efficiently allocated, due to excessive concentration of transactions in particular issues purchased by the Bank. Furthermore, if these supporting measures are maintained for too long, there is a possibility that the economy will overheat, resulting in large fluctuations in economic conditions and prices. Therefore, to decide when and how these exceptional policies should be withdrawn is also an important policy issue. When making decisions, not only should developments in corporate financing and financial markets and effects of these policy measures be assessed carefully, but also it is important to plan an exit in a way that market participants can anticipate and not bring about unnecessary market disturbances. For this reason, an expiry date was set for these measures from the beginning. Originally, when the Bank began these measures, such as the outright purchases of CP, the expiry date set was at the end of March this year. However, given that conditions in financial markets and corporate financing were extremely tight in the run-up to the fiscal year-end and that this situation was expected to continue for the time being, in February the expiry date was extended to the end of September this year. At the MPM held last week, the expiry date of measures to facilitate corporate financing was extended further to the end of December. This was because the Bank judged that facilitating corporate financing was still necessary given that, while there were continued signs of improvement, financial conditions remained generally tight. The Bank will decide whether to terminate, alter, or further extend these measures by the end of December, which is the new expiry date. The Bank will, without any predetermined view, carefully assess developments in corporate financing and financial markets, and will decide, at an appropriate timing, whether the support offered by the current measures is still necessary. Closing remarks So far I have explained Japan's economic situation and the Bank's policy responses. In closing, I would like to say a few words about my impression of the economy of this region. Local economies in Japan are in a difficult situation, faced with many structural issues such as a declining and aging population. I fully understand that, in this situation, restructuring the business model for the future is easier said than done. With regard to Hakodate, however, it is blessed with a famous night view as well as many other excellent tourist attractions such as Goryokaku, Yunokawa hot springs, and Onuma National Park. In addition, there is not only the key industry of processing marine products but also industrial bases such as shipbuilding, electronic parts manufacturing, and dairy products. Furthermore, the port of Hakodate links these tourist attractions, products, and technologies with other parts of Japan as well as overseas, and the area enjoys high potential as a center of transportation and logistics. Developing new businesses utilizing these advantages, despite the big challenges, offers great opportunities. With a sense of expectation, I look forward to your active involvement and to further economic development of this region. The Bank will continue to firmly support the economic activity of the nation's regions from the financial side and to exert its utmost efforts as the central bank to facilitate the return of Japan's economy to a sustainable growth path with price stability. Thank you very much for your attention.
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Remarks by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Conference co-hosted by the People's Bank of China and the Bank for International Settlements, Shanghai, 8 August 2009.
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Masaaki Shirakawa: Unconventional monetary policy – central banks: facing the challenges and learning the lessons Remarks by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Conference cohosted by the People's Bank of China and the Bank for International Settlements, Shanghai, 8 August 2009. * * * Introduction Currently, major central banks have introduced "unconventional monetary policy measures" to deal with the economic and financial crisis that materialized in the aftermath of the bursting of the global credit bubble. In this regard, the Bank of Japan has clearly been a forerunner since the latter half of the 1990s. Today, I would like to talk about some of the issues surrounding unconventional monetary policy, while reflecting upon the experiences of the Bank of Japan during the latter half of the 1990s and the earlier part of this decade. Bank of Japan's monetary policy since the latter half of the 1990s In order to refresh the memories of conference participants, I will begin by listing the innovative elements of Bank of Japan's monetary policy since the latter half of the 1990s, including those which were not necessarily considered to be innovative by outside observers at that time. First, the overnight interbank rate was brought down to truly zero, to be precise 0.001%. Second, we introduced "quantitative easing" by setting the outstanding amount of reserves at the central bank as an operational target and by raising it to levels well beyond the required amount. At its peak, the excess reserves were 29 trillion yen or 5.8% of nominal GDP. This compares with 6.2% for the Federal Reserve and 3.5% for the European Central Bank during the current global crisis. Third, we extended the maturity of funds-supplying operations. In 2005, during the final phase of quantitative easing, the average maturity of funds-supplying operations was over six months and the longest operation extended up to eleven months. Fourth, we made commitments on the duration of zero interest rates and quantitative easing. Fifth, we commenced what is now called "credit easing" by purchasing ABCP and ABS. Sixth, although not necessarily part of monetary policy, the Bank of Japan purchased stocks from banks' equity portfolios in order to help reduce the market risk associated with their shareholdings, which was a significant destabilizing factor for the Japanese financial system. In a nutshell, the Bank of Japan had, in previous years, adopted many of the innovative measures which are now being introduced on a global scale. Challenges for the Japanese economy and the Bank of Japan Though needless to say, such unconventional monetary policy measures were initiated to deal with the difficulties that the Japanese economy confronted at that time. Each crisis is different. But overall, there are many common elements with the challenges that the economies and central banks in Europe and North America are now facing. Specifically, I can raise five points. First, the risk taking capacity of various economic entities was severely damaged, and, as a result, the effectiveness of conventional monetary policy was seriously hampered. Second, in such an environment, the overnight interest rate dropped down to zero, limiting the room for additional easing through conventional monetary policy measures. In Japan's case, the overnight rate fell to 0.5% five years after real estate prices peaked in 1990. In the US, policy actions were faster, but still three years had passed after the residential real estate prices peaked in 2006, before overnight rates came down to levels seen in Japan. Third, it took time to recapitalize the banking system, which was most effective and vital in revitalizing the economy. The injection of public capital into weakened financial institutions was indispensable in stabilizing the financial system, but was politically unpopular. In the current crisis, European and US authorities have deployed such measures much faster than the Japanese case. But more than a year passed after the initial shock which occurred in the summer of 2007, before such measures were initiated. Fourth, reflecting the situation I have just mentioned, uncertainty regarding the transmission mechanism of monetary policy is much larger than in normal times. Therefore, regardless of whether experimental types of monetary policy measures were introduced or not, explaining the intentions of monetary policy decisions to markets and to the public at large, or in other words, fulfilling their accountability obligations became a key challenge for central banks. Fifth, when central banks try to create "productive" policy measures, in an environment where the effectiveness of traditional monetary policy is constrained, they naturally come close to the area of fiscal policy. As a result, the policymakers need to face up to the issue of who should be responsible for such policy actions in a democratic society. The challenges for central banks How should central banks deal with such issues? The answer depends on multiple factors. They include, among others, the economic and financial environment which each central bank faces, and the laws which set out the responsibilities of each central bank and the policy tools at its disposal. There is no single universal answer which transcends both borders and the passage of time. I would like to explain my perspectives on unconventional monetary policy, building upon the experiences from both the last Japanese crisis and the current global crisis. First, the most essential point in dealing with a financial crisis is to maintain the stability of financial markets and the financial system. Central banks need to exert maximum effort in this area. After all, in times of crisis, that is what central banking is all about. In this regard, the Bank of Japan introduced quantitative easing, credit easing, and stock purchases. With respect to Japan's quantitative easing, although the stimulative effects on economic activity through monetarist channels seemed to be self-evident in the eyes of quite a number of economists, the financial system perspective was not fully appreciated. However, looking back, the most important benefit of quantitative easing was its contribution to financial market and financial system stability through the provision of abundant liquidity. 1 In the current crisis, major central banks have expanded their balance sheets, but excluding the Bank of England, they have not characterized their measures to loosen monetary policy as quantitative easing. This certainly is understandable when we look back on the Japanese experience, where the effectiveness of quantitative easing on real economic activities has not been confirmed. Second, as I mentioned, in order to stabilize the financial system, the injection of capital into the banking system together with the provision of liquidity is indispensable. This alleviates pressure on the financial intermediation process, but it is not sufficient to resolve the fundamental problem which had lead to the crisis. This raises the third point. The unwinding of various excesses which have built up in the nonbanking private sector is just as critical. We must not forget that the injection of public funds as capital into the banking sector as well as the provision of abundant liquidity through, for As for the effect of quantitative easing, see Bank of Japan (2005), Shirakawa (2004, 2005), Ugai (2007). example, quantitative easing do not alleviate the need for the unwinding process in the nonbanking sector. It must be recognized that some time is necessary before excesses are unwound and the economy can return to a sustainable growth path. The length of time necessary will depend on the size of the imbalances which build up during the bubble period, and the severity of the negative feedback effect magnified by the loss of confidence during the crisis that follows. In any case, it will not be brief. 2 The fourth issue is the fine line between monetary policy and fiscal policy. Measures to take on individual credit risk such as corporate debt are extraordinary steps for a central bank since they come close to the area of fiscal policy which deals with resource allocation at the micro level. I believe such measures are only justified when we are facing a situation where, if left untouched, there is a substantial risk that credit market functions will deteriorate and the resulting weakening of the financial conditions can seriously damage the economy. It must also be compatible with the legal framework provided in each country's central banking law. When such measures are introduced, in order to avoid constraining market functioning where market participants become reliant on such extraordinary measures, it would be important to have an appropriate built-in exit mechanism which reduces the incentive to use the facility as market functioning recovers. Additionally, since it is in essence close to the realm of fiscal policy, a clear understanding of which authorities are taking on the risks involved is indispensable. This is also important from the perspective of maintaining public confidence in the financial strength of the central bank. If the central bank's financial strength is perceived to be weakened, concerns may arise, subtly through various channels, with regard to its ability to effectively fulfill its monetary policy mandate. Fifth is communication with the markets. Without public trust in the organization, a central bank cannot effectively conduct monetary policy. Words and deeds have to match. There is much uncertainty with regard to the effectiveness of unconventional monetary policy and extraordinary measures may be pushing the boundary of monetary policy. Because of these two aspects, thorough communication with markets and the public becomes all the more important. Careful explanations while continuously evaluating both the positive and adverse effects of the steps taken become critical. Even during times of a crisis, if central banks take time-inconsistent policy measures, this could rather have negative effects on confidence in the central bank, and as a result reduce the effectiveness of monetary policy. At the end of the day, the central bank needs to communicate its aims and strategies in response to the characteristics of the problem the economy faces, and also needs to take policy measures which are consistent with the communication. I would like to emphasize once again that, especially in a crisis situation, the central banks must make clear their commitment to the stability of financial markets and the financial system, and take decisive policy actions to achieve such goals. Concluding remarks The five issues I raised today were those which the Bank of Japan struggled to solve when it last embarked on unconventional monetary policy. The difference between now and then is that the practical difficulties in dealing with such issues were not fully appreciated by many economists at that time. I am sure many of you can recall the various policy recommendations that were made toward Japan's policymakers by economists, both domestically and from abroad, as well as from international organizations since the latter half Ahearne et al. (2002) analyzed the Bank of Japan's monetary policy conducted during the 1990s, and showed the simulation result that deflation could have been avoided if the Bank of Japan had cut its policy rate to a great extent immediately after the bursting of the asset price bubble. There have been cases where an optimistic view has been expressed, partly based on such analysis, that a recession after the bursting of a bubble could be dealt with by aggressive monetary easing. For instance, Mishkin (2007) noted that, as long as a central bank timely responds to the bursting bubble, its harmful effect can be kept to a manageable level. of the 1990s. Recommendations, some of which were quite bold, were made to the Bank of Japan. Typical recommendations were: "all that the Bank of Japan needs to do is to set a high inflation rate target and purchase all types of assets including physical assets to achieve that target", and "the Bank of Japan should monetize the government's budget deficit". One of the most famous was, "the central bank should credibly promise to be irresponsible". 3 Interestingly, in the current crisis, in spite of the sharp contraction of the economy, very few similar bold recommendations are being made by economists, and such radical measures are not being implemented. As we experience first time challenges, the discussion surrounding policy measures tends to swing between the extremes. Such discussions become truly practical once people actually face the challenge of dealing with a crisis. Viewing such changes, I believe that the learning process, the process of moving forward while learning the lessons from past experiences, is working effectively. What is important is to fulfill our basic responsibilities as a central bank. In this regard, an important challenge for us central bankers is to continue to humbly work to increase our understanding of changes in the economy and financial system and enriching our knowledge regarding the workings of the economy and the art of central banking. Thank you. Reference Ahearne, Alan, Gagnon, Joseph, Haltmaier, Carter, Kole, Linda, Roush, Jennifer, and John Rogers, "Preventing Deflation: Lessons from Japan's Experience in the 1990s," International Finance Discussion Papers Number 729, Board of Governors of the Federal Reserve System, 2002. Bank of Japan, "Outlook for Economic Activity and Prices, October 2005," 2005. Krugman, Paul, "It's Baaack: Japan's Slump and the Return of the Liquidity Trap", Brookings Paper on Economic Activity 2, pp.137-205, 1998. Mishkin, Frederic, S., "Housing and the Monetary Transmission Mechanism," Finance and Economics Discussion Series 2007-40, Board of Governors of the Federal Reserve System, 2007. Shirakawa, Masaaki, "Comment to "Securing the Peace after a Truce in the War on Inflation," by Vincent R. Reinhart" in the 11th International Conference sponsored, Monetary and Economic Studies, Vol.22, No.S-1, Institute for Monetary and Economic Studies, Bank of Japan, pp.208-215, 2004. ------------------, "Speech in the Concluding Panel Discussion," in the 12th international conference, Monetary and Economic Studies, Vol.23, No.S-1, Institute for Monetary and Economic Studies, Bank of Japan, pp.243-248, 2005. Ugai, Hiroshi, "Effects of the Quantitative Easing Policy: A Survey of Empirical Analyses," Monetary and Economic Studies, Vol.25, No.1, Institute for Monetary and Economic Studies, Bank of Japan, pp.1-47, 2007, See Krugman (1998).
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Remarks by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Federal Reserve Bank of Kansas City's Annual Economic Symposium, Jackson Hole, Wyoming, 21 August 2009.
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Masaaki Shirakawa: International policy response to financial crises Remarks by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Federal Reserve Bank of Kansas City's Annual Economic Symposium, Jackson Hole, Wyoming, 21 August 2009. * * * Introduction I will explore the future of international coordination between central banks in the wake of the current financial crisis. Here, I mean by coordination between central banks that they attempt to respond to and stave off a global crisis effectively in an organized way without any outside pressure. The current crisis has posed enormous challenges on many fronts to policymakers. As the starting point for discussing those challenges, I think it is important to highlight three facts. First, the global economy has encountered a crisis more frequently in the past 20 years than before. Second, the current crisis has grown literally into a global crisis. The global economy has contracted sharply since the fall of 2008, as often described as falling off a cliff. By contrast, the prior crises such as Japan’s post-bubble period and the East Asian crisis still remained local, even though they exerted significant adverse effects on the domestic or regional economy. 1 Third, the soundness of financial institutions before the crisis differed significantly between those countries in question. Asian financial institutions, including Japanese institutions, as well as Canadian and Australian ones, had smaller exposure to complicated structured products, compared with U.S. and European institutions. Those three points provide a sound basis for considering how to forestall a crisis. Causes for global financial crisis Here, I will try to summarize some stylized facts about the unfolding of crises, including the current one. During a pre-crisis period, benign economic conditions, just like the “Great Moderation” prior to the current crisis, usually prevail for some time, and the risk-taking attitude of economic agents becomes aggressive. In economic analysis, economic agents’ preferences are assumed to remain unchanged over time. But, in reality, risk perception becomes optimistic and risk tolerance is elevated under benign economic conditions. Unfortunately, our knowledge of a mechanism of such endogenous changes in the risktaking attitude, or risk-taking channel, is quite limited. Institutional arrangements, such as regulation, valuation, and compensation, shape incentives at a micro level. Given institutional arrangements, an actual implication of such incentives is importantly influenced by the financial and economic environment at a macro level. In that respect, low inflation and high growth coupled with low volatility of the two certainly play an important role in fostering bullish sentiment. In addition, a sense of unlimited availability of liquidity transforms such bullish sentiment into excessive risk-taking. In the process of risk-taking, financial imbalances are being accumulated in various forms, such as expansion of credit and leverage, an increase in maturity mismatches, and a surge in asset prices. The build-up of financial imbalances is hardly sustainable over time and a balance sheet adjustment eventually takes place. The adjustment initially proceeds in a gradual pace. Then a crisis comes to the surface in the form of a severe liquidity shortage triggered by some shocks, and it deepens when confidence among financial market Japan's 1990s is often referred to as the “lost decade.” For the appropriateness of such characterization, see Shirakawa (2009a). participants collapses. Market liquidity declines in wide-ranging markets and an adverse feedback mechanism starts working between the financial system and the real economy. Capital shortages at financial institutions become apparent, although the very distinction between a liquidity shortage and a capital shortage becomes blurred in a crisis. Then, what made the current crisis truly a globalized one, in contrast to the aftermath of Japan’s bubble burst and the East Asian crisis? First, during the pre-crisis period, excess liquidity prevailed on a worldwide basis, and thus, the financial imbalances expanded massively and spread out over a wide range of regions around the globe. A variety of factors worked in a complicated manner behind the scenes, and expectations for the continuation of low interest rates among industrial countries certainly played an important role in expanding financial imbalances by generating a false sense of abundant liquidity. By contrast, in the case of Japan’s bubble, the outstanding performance in terms of both inflation and growth was to a large extent an isolated phenomenon. Headline CPI for Japan remained already at a low level, just below 1 percent on average between 1985 and 1989, whereas that for G-7 excluding Japan and Germany still remained around 5 percent. The overall picture of inflation performance remained almost unchanged when using the core measures, like excluding food and energy prices. Thus, there was virtually no synchronization in expectations for prolonged low interest rates on a worldwide basis. Second, the increased interconnection between financial institutions made the adjustment in the current crisis more acute and globally synchronized. Financial institutions had become highly interconnected on a worldwide basis before the crisis. A case in point is a surge in cross-border lending. Cross-border lending by banks in industrial countries toward emerging economies continued to increase over time, and has accelerated since 2003. Lending toward Central and Eastern Europe by euro area banks was more conspicuous. That process inevitably involved the expansion of a dual mismatch, that is, a currency and maturity mismatch, which was supported by a sense of abundant liquidity in both domestic and foreign currencies. In the wake of the crisis, fragility stemming from the dual mismatch abruptly exerted severe funding pressures, further deepening the crisis in many countries, including emerging economies. By contrast, during Japan’s bubble era in the late 1980s, the increase in cross-border lending was not globally observed and mostly limited to Japanese financial institutions. As a related issue, “the global savings glut” is often pointed as one of the causes for the global credit bubble, but I am a little skeptical about that line of argument. It is true that savings by emerging economies are one of its determinants, since global real interest rates are determined so as to equate the savings and investment in the global economy. To understand the phenomenon of the global credit bubble, however, gross capital flows are far more important than net capital flows. The gross capital flows do not necessarily correspond to the savings-investment balances at a national and regional level. In fact, it was euro area banks that strikingly expanded cross-border lending, while the euro area as a whole did not register a current account surplus. International coordination: assessment on the current crisis responses To the extent that a crisis becomes increasingly globalized, greater cooperation among policymakers will be called for. How should policy responses so far be assessed from the viewpoint of international coordination? I will start with positive developments. First, governments and central banks in many countries have carried out aggressive macroeconomic policy responses to stave off a significant deterioration in economic activity. Second, many countries have provided public capital to financial institutions and instituted government guarantees on their liabilities. Third, coordination between central banks in conducting money market operations has advanced significantly. A case in point is the U.S. dollar funds-supplying operations at many central banks, backed by the U.S. dollar swap arrangements with the U.S. Federal Reserve. Fourth, the prior collaborative efforts by central banks and private financial institutions in reducing settlement risk have proven effective. The functioning of currency swap markets, which plays a key role in linking interbank markets in many countries, crucially depends on perceived settlement risk. In that regard, the continuous linked settlement (CLS) mechanism, which started in 2002, proved quite effective. Without such a payment-versus-payment service for foreign exchange transactions, the global financial system would have been in deeper turmoil through the amplification of counterparty risk due to further risks associated with time zone differences. Of course, it is a hard fact that various limits exist in international coordination. First, measures to stabilize the financial system in each country have hastily been introduced without necessary harmonization between the countries. That has created some gaps in the range of government guarantees for depositors and creditors between the countries, thereby triggering sudden international shifts in deposits. Second, financial institutions have been increasingly asked to serve for the domestic “interests” and sort of “financial nationalism” seems to have emerged. Third, in some countries, the aggregated balance-sheet size of domestic financial institutions expanded far beyond nominal GDP, thus making it increasingly difficult to take necessary policy actions, including public capital injections. The observations I have just mentioned indicate the limitations in international coordination, in the sense that the global or world-wide optimum has not necessarily been chosen. Like it or not, that is a reality and such limitations do arise for a couple of reasons. First, with public money injections, a government is in a position to pay more attention to taxpayers’ interests, and naturally has incentives for ring-fencing interests of its own country. Second, bankruptcy legislation for financial institutions differs between countries. As the Bank of England Governor Mervyn King put it, “global banking institutions are global in life, but national in death.” 2 Challenging conventional wisdom The limitations I have just mentioned are, for the most part, sort of a coordination failure due to the very existence of sovereign nations. We cannot deny the importance of making efforts to avoid a coordination failure, but it seems more productive for each policymaker around the globe to address the common factors causing crises. In that regard, we should take seriously the fact that the frequency of crises has increased in the last 20 years, and the crises have also become increasingly globalized. For those reasons, it seems natural to reflect on the relationship between that fact and conventional wisdom underpinning monetary policy, and financial regulation and supervision. Put it simply, the prevailing philosophy among central banks and other policy authorities rests on three forms of “pre-established harmony,” if you please. First, macroeconomic stability can be achieved by monetary policy, which pursues low and stable inflation. Macroeconomic stability is complementary to financial stability. Second, financial stability can be achieved by pursuing a microprudential approach. To that end, the authorities need to properly regulate and supervise individual financial institutions. As a key tool, capital adequacy regulation has become increasingly sophisticated to calibrate risk involved in a specific activity. Third, financial institutions with a sufficient capital position can easily raise liquidity in financial markets. Thus, liquidity consideration has been assigned only an ancillary role in regulation and supervision. See Financial Services Authority (2009). Way of thinking about monetary policy management It is a good time to review the prevailing philosophy in light of the current crisis. On the first form of the pre-established harmony on macroeconomic stability, monetary policy aimed at low and stable inflation was so successful in the past two decades. Oddly, such success of monetary policy also turned out to be a part of the problem. Given human psychology and institutional arrangements, the unfounded expectations for the continuation of low interest rates were responsible for creating perverse incentives under benign economic conditions. Such perverse incentives in turn induced the process of accumulation and manifestation of financial imbalances, thereby destabilizing the economy in the longer term. 3 The issue we are facing is sometimes inappropriately described as an intra-temporal tradeoff between price stability and financial stability. The actual trade-off here is an inter-temporal trade-off between the current and the future economic stability. Lively debate on the possible role of monetary policy is going on. Monetary policy alone cannot or should not stave off a bubble. Indeed, it bears a more modest but important task. Monetary policy should avoid accelerating a bubble through creating unfounded expectations for the continuation of low interest rates, since incentives are underpinned ultimately by the financial and economic environment at a macro level. 4 Capital adequacy regulation and incentives The second form of pre-established harmony on microprudential policy also needs to be reexamined. A macroprudential perspective is definitely needed in assessing risks as well as in designing regulations. The very fundamental problem is how to stem intrinsic moral hazard due to the limited liability of stockholders. In the past 20 years, the financial regulatory and supervisory authorities have attempted to tighten capital adequacy regulation. With low leverage, however, financial institutions faced difficulty in achieving sufficiently high return-on-equity to satisfy bank stockholders, which then induced the expansion of “shadow banking.” 5 An alternative business strategy was to raise return-on-asset, but the franchise value of financial institutions tended to be declining over time due to financial deregulation and intensified competition. The declined profitability put pressure on some financial institutions to take an excessively high risk. 6 The regulatory and supervisory authorities count on self-discipline at private financial institutions as well, because the authorities are well aware that they are unable to monitor every detail of business activity at private financial institutions. At the same time, as the authorities hardly count solely on such private initiatives, they impose regulations on private financial institutions to avoid the manifestation of systemic risk. Central to the issue is how to balance public regulation and self-discipline at private financial institutions as well as capital adequacy regulation and other forms of public regulation. 7 See Rajan (2006) and Bank for International Settlements (2009) for the further discussion on perverse incentives under benign economic conditions. See Shirakawa (2009b, c) for further discussion on implications of incentives at micro- and macro-level on a financial crisis. Gorton (2009) points out the importance of understanding the “shadow banking system” as a genuine banking system in designing new financial regulation. See, for example, Institute for International Finance (2009) for the discussion on the profitability of financial institutions and the stability of the financial system as a whole. Nishimura (2009) points out the importance of striking a balance between benefits and costs in designing financial regulation. Given the limited liability of stockholders, strengthening capital adequacy regulation alone will not be effective enough to constrain the short-sighted behavior of stockholders and business executives. In any event, the most important challenge to ensure financial stability is how we can strengthen credit underwriting discipline and liquidity management, which, after all, provide the most reliable protection for the sound financial system. 8 In that regard, it should be noted that the pendulum has swung back and forth in the discussion of models for financial regulation and supervision. Simply put, the Asian model was downgraded after the Asian crisis, and the Anglo-Saxon model was also downgraded this time, although the exact meaning of those models has remained vague. It should be also noted that the soundness of financial institutions before the crisis differed between the countries. With that observation, I do not intend to suggest that one model is superior to the other. Rather, that seems to suggest the importance of versatility of financial regulatory and supervisory models. 9 In view of the situation in each country, we need to think over what kind of combination of public regulation and self-discipline is desirable, and what kind of combination of capital adequacy regulation and other forms of public regulation is desirable. For example, even in the age of globalization, the factors influencing incentives, such as executive compensations, differ considerably between the countries. Liquidity transfer Turning to the third form of pre-established harmony on the availability of liquidity, as shown by the experience of the current crisis, counterparty risk, whether actual or perceived, plays a crucial role in aggravating a crisis. Even a well-capitalized financial institution cannot easily raise liquidity in financial markets in a crisis. Thus, we should put more emphasis on building financial infrastructure less vulnerable to shocks. One of the key actions here is to ensure smooth liquidity transfer across currencies, time zones and regions. The payoff of such efforts will be more solid and substantial, even though it does not make the headlines. Necessity of cooperation and coordination between central banks In relation to the three challenges above, I will next explain the necessary efforts in the area of cooperation and coordination between central banks. First, regarding monetary policy, each country should make every effort to put its own house in order. Central banks also need to put more collaborative efforts into making an analysis of global financial conditions and enhancing further information sharing. I find it increasingly important to monitor the international dimension of the risk-taking channels with regard to the transmission mechanism of monetary policy. That dimension is typically observed as the common lender channel, by which I mean internationally active financial institutions playing a role in transmitting monetary policy effects, and global investors taking carry-trade positions in various forms. Next, in terms of financial regulation and supervision, putting its house in order in each country is again the most important principle for ensuring financial stability. The experience following the collapse of Lehman Brothers shows its importance succinctly. On top of that, it is crucial to make further effort to redesign the regulatory framework to stave off a future crisis. In that regard, we are working definitely in the right direction to embrace a macroprudential perspective. As we are charged with so many tasks in our agenda, some caution should be needed not to lose a holistic view. G20 and Financial Stability Board (FSB) Fisher (2009) emphasizes the importance of incentives as the principle lesson from the current crisis. See Goodhart (2009) for an assessment of the Anglo-Saxon model of banking and financial regulation and supervision in light of the current crisis. have correctly proposed to review the capital adequacy standards, with a reservation of implementing most of the new rules once recovery is assured. 10 Such a policy direction seems relevant in light of the amount of risk actually taken by internationally active financial institutions in recent years. In implementing the policy, however, we also need to pay attention to the endogenous changes in financial institutions’ risk-taking stemming from strengthened capital regulation. Finally, coordination between central banks is required in the area of money market operations, and, more generally, banking policy. A crisis is likely to be amplified by concern over funding liquidity. That underscores the importance of the efforts to transfer liquidity smoothly on a global basis. U.S. dollar funds-supplying operations, carried out under coordination between major central banks, have been highly effective under such conditions. In that case, other central banks than the Fed have an incentive to implement operations to secure the stability of domestic financial markets and domestic financial institutions. The Fed also has a natural incentive to secure the stability in U.S. dollar denominated financial markets. As a result, U.S. dollar funds-supplying operations are mutually beneficial for both the Fed and other central banks. That point is markedly different from “international policy coordination” in monetary policy, easily placing strain on bilateral relations in key variables, such as foreign exchange rates and the balance of payments. Through the current crisis, we have reconfirmed that it is important to make currency swap, repo, and other collateralized markets more robust, and that central banks need to promote private initiatives in that direction. From that perspective, central banks need to make further coordination in providing liquidity, accepting cross-border collateral, and extending operating hours for the payment and settlement systems provided by central banks. Concluding remarks In closing, I emphasize the importance of promoting human interaction in further developing coordination between central banks. Since the summer of 2007, central banks have communicated with each other intensively at various levels, from top central bankers to mid-class staffers using various tools, such as emails, conference calls, and face-to-face conversations. Such efforts have contributed to preventing the crisis from worsening further. Financial markets are inevitably incomplete in economists’ terminology, and it is professional judgment that fills the gap inherent in the incomplete contracts. In that sense, the deepened mutual trust, the accumulated practical and operational know-how, and the strong network of central banks, which have been established during the process of crisis management, provide a basis for substantive cooperation. A new international financial system, if that in fact comes true, will emerge from the wealth of human network. References Bank for International Settlements, 79th Annual Report, 2009. Financial Services Authority, The Turner Review: A Regulatory Response to the Global Banking Crisis, 2009. Fisher, Peter R., “The Market View: Incentives Matter” in John D. Ciorciari and John B. Taylor eds., The Road Ahead for the Fed, Hoover Institution Press, 2009. See G20 (2009) for the proposal for strengthening financial regulation and supervision. Goodhart, C. A. E., “Banks and the Public Sector Authorities,” Paper presented at PBC-BIS Shanghai conference on August 6-8, 2009. Gorton, Gary, “Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007,” mimeo 2009. G20, G20 Finance Ministers’ and Central Bank Governors’ Communiqué – 14 March, 2009. Institute for International Finance, Restoring Confidence, Creating Resilience: An Industry Perspective on the Future of International Financial Regulation and the Search for Stability, 2009. Nishimura, Kiyohiko G., “Financial System Stability and Market Confidence,” Speech at the Japan Society of Monetary Economics' Spring Annual Meeting, May 16, 2009. Rajan, Raghuram G., “Monetary Policy and Incentives,” Address at the Bank of Spain Conference on Central Banks, June 2006. Shirakawa, Masaaki, “Way Out of Economic and Financial Crisis: Lessons and Policy Actions,” Speech at Japan Society in New York, April 23, 2009a. ______, “Preventing the Next Crisis: The Nexus between Financial Markets, Financial Institutions and Central Banks,” Speech at the London Stock Exchange, May 13, 2009b. ______, “Some Thoughts on Incentives at Micro- and Macro-level for Crisis Prevention,” Remarks at the Eighth Bank for International Settlements Annual Conference in Basel, Switzerland, June 26, 2009c.
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Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at a meeting with Business Leaders, Osaka, 31 August 2009.
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Masaaki Shirakawa: Recent economic and financial developments and the conduct of monetary policy Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at a meeting with Business Leaders, Osaka, 31 August 2009. * * * Introduction I am honored to be here today to speak and to exchange views with business leaders from the Kansai region. I take this opportunity to express my deep gratitude for your cooperation with the Bank of Japan's branches in Osaka, Kobe, and Kyoto. Before we exchange views, I will first speak about the background to the recent economic recovery and the economic outlook, as well as the Bank's thinking behind the conduct of monetary policy. At the gathering held at the end of August last year in Osaka, I mentioned two things about Japan's economic outlook. One thing was that growth would likely remain sluggish for the time being. And the other was that, even so, there was a remote possibility that Japan's economy would experience a crucial adjustment phase. I presented a cautious outlook that growth would likely remain sluggish for the time being because I judged that the accelerated rise in energy and materials prices at the time as well as the effects of the bursting of a global credit bubble triggered by the subprime mortgage problem would continue to weigh on the economy at home and abroad in the form of balance sheet adjustments. While I believe that the judgment itself was a valid one, as for the part that there was a remote possibility that Japan's economy would experience a crucial adjustment phase, it turned out that the possibility became a reality and the economy followed a bumpier road than envisaged at the time. Needless to say, the direct cause was the collapse of Lehman Brothers in September last year. Because of that, a liquidity crisis emerged on a global basis, and we faced a serious situation that confidence, which could be said as a prerequisite for the normal functioning of financial markets, collapsed. As a result, the economic conditions deteriorated simultaneously and sharply worldwide, the situation no policy authorities around the globe ever imagined. In fact, looking back on the changes in the International Monetary Fund's forecast for world economic growth for 2009, it was plus 3.9 percent in July last year, but was subsequently revised downward for several times to become minus 1.4 percent in July this year. The sheer fact that the forecast for the growth rate was revised downward by more than 5 percentage points in a period of only one year illustrates how rapidly the world economic conditions deteriorated during that period. There is finally a glimmer of recovery in the economy at home and abroad. Nevertheless, as many people might feel, there is still considerable uncertainty about future developments. I. Developments in the global economy I will start with the current global economy. As I have just mentioned, the factors behind the global economic slowdown since last autumn, which correlate with each other, can be broadly divided into two factors. One is the global accumulation of excesses during the mid-2000s and the adjustments of the balance sheets of firms, households, and financial institutions emanated in the process of the unwinding of excesses. The other is the liquidity crisis triggered by the collapse of Lehman Brothers, and the resulting panicky contraction of financial and economic activity. Let me explain the first factor little more in detail. Up to the mid-2000s, the world economy had marked high levels of growth at around 5 percent for four consecutive years. With hindsight, centering on the United States and Europe, a large credit bubble was formed and excesses in financial and economic activity in various aspects emerged during that period. In the area of financial activity, credit and leverage increased substantially as exemplified by the subprime mortgage problem. The economic activity also overheated. The examples are a substantial increase in housing investment in the United States and a surge in demand for durable goods around the world. In the meantime, a bullish economic outlook prevailed among firms, and they substantially augmented their production capacity. However, high growth supported by the credit bubble cannot continue for long. The world growth started to slow around the beginning of 2008. The essence of what is happening now is an adjustment to bring excessive capital stock and debt back to normal levels, and business fixed investment and private consumption are contained. Financial institutions have also been striving to reduce their impaired assets and to resolve excessive leverage. In such a process, financial institutions' proactive lending capacity will necessarily decline. Therefore, during the period of balance sheet adjustments, it is inevitable that the global economy remains under downward pressure. If such balance sheet adjustments are to impose "chronic illness" on the economy over a long period, the liquidity crisis, which was the second factor behind the global economic downturn, would bring a powerful "acute pain" that contracted economic activity at a stroke. As I have mentioned, triggered by the collapse of Lehman Brothers, providers of funds, such as financial institutions and institutional investors, became extremely cautious about counterparties' creditworthiness. That led to a sharp decline in transactions, not only in the interbank market where banks exchange funds but also in the CP and corporate bond markets where firms raise funds. As a result, the functioning of financial markets declined at a stroke, and the funds necessary for economic activity did not prevail. That, together with firms and households' intensified anxiety, shrank the global financial and economic activity in a panicky manner. The global economic conditions seem to have stopped worsening this spring. That is because the "acute pain" has started to dissipate for the following three reasons. First, ample fund supply by central banks and an aggressive injection of public funds into U.S. and European financial institutions have proved effective, and global financial markets have been regaining stability. Second, inventory adjustments have progressed as a result of a substantial production cutback. And third, once plunged demand is now showing signs of gradual recovery, thanks to the effects of a large-scale economic stimulus around the globe. Those developments are likely to continue for some time. If that is the case, what becomes more important from now is how to assess the effects of balance sheet adjustments centering on the United States and Europe, which was the first factor behind the current economic downturn. However, that point is associated with high uncertainty. It takes a considerable period of time to complete the balance sheet adjustments following the experience of a large bubble. A possibility cannot be denied that the factors including the continued decline in the U.S. commercial real estate prices will make the adjustments more significant than envisaged in terms of duration and magnitude. Meanwhile, emerging economies including China have recently been showing growth slightly stronger than expected. A large-scale economic stimulus in China has exerted favorable effects on the neighboring East Asian countries, seemingly playing a role of raising economic growth of the regions as a whole. The Bank will also pay attention to how the bold monetary easing in advanced countries affects emerging economies where the problem of balance sheet adjustments is relatively small. II. The current state of and outlook for Japan's economy Based on the picture of the global economy, I will now move on to the current state of and outlook for Japan's economy. From the autumn of last year, Japan's economic conditions worsened far more sharply than those in the United States and Europe where the current crisis had started. Japan's real GDP growth recorded a more than 10 percent decline on an annualized basis for two consecutive quarters in the October-December quarter of last year and the January-March quarter of this year. The reason why economic conditions deteriorated in Japan more seriously than those in other countries was that the high-tech manufacturing industries including automobiles, electrical machinery, and general machinery, which benefited from the recent high growth of the global economy, had a high share in Japan's economy. A fall in global demand especially for durable goods and capital goods owing to the rapid contraction of global economic activity directly hit those industries, resulting in a substantial decline in exports and production. Since this spring, as the "acute pain" of the global economy has started to dissipate, there has been a reversal of the mechanism which I have just mentioned. That was illustrated by the April-June real GDP growth rate of 3.7 percent, on an annualized basis, which was the highest growth in the G-7 countries. With progress having already been made in inventory adjustments both at home and abroad, the recovery in exports and production has increasingly become obvious, centering on automobiles and electronic parts. In particular, against a backdrop of China's strong demand for electrical appliances, exports to East Asia first rebounded early this spring. Signs of improvement remain observed not only in the real economy, but also in corporate financing. The issuing rates of CP and corporate bonds, which surged from last autumn, have declined to the levels seen before the collapse of Lehman Brothers. While only a handful of firms with high ratings could issue corporate bonds up to the end of last year, the situation improved significantly such that the issuance was a record high this June. Firms' financial positions have continued to improve particularly at large firms. While some yelps were once heard from firms' managers and treasurers on their financial positions, they seem to have materially regained their composure recently, albeit still not being able to dispel uncertainty about the future outlook. Looking ahead, Japan's exports are expected to continue to increase as the overseas economies start recovering. The resultant recovery in corporate profits and the effects of various policy measures will likely bring about a gradual recovery in business fixed investment and private consumption. Therefore, the Bank's baseline scenario is that "Japan's economy will start recovering from the latter half of fiscal 2009." However, I will hasten to add that the Bank judges that the pace of recovery is highly likely to be only moderate. Given that the global adjustments of balance sheets will continue, it is hard to assume a marked and rapid recovery in exports. In addition, against a backdrop of excessive capital stock and the severe employment and income situation, business fixed investment and private consumption are likely to remain relatively weak for the time being. As I have mentioned earlier, it is still not clear how the balance sheet adjustments centering on the United States and Europe will proceed. The Bank will continue to carefully examine financial and economic developments at home and abroad, while paying due attention to various risks surrounding Japan's economy. III. The Bank's thinking on prices I will now move on to the developments in prices in Japan. Since recording an increase of 2.4 percent in the summer 2008, the year-on-year rate of change in the consumer price index (CPI) for all items excluding fresh food has been on a declining trend and has been negative since March this year. The rate of change for July, released at the end of last week, marked a decrease of 2.2 percent on a year-on-year basis, the largest decrease ever recorded. The same can be said about other countries. Looking at the rates of change in consumer prices for all items in July, they were negative in all G-7 countries but for the United Kingdom – for example, minus 2.2 percent in Japan, minus 2.1 percent in the United States, and minus 0.7 percent in Germany. In addition, the average rate of change for G-7 countries declined year on year by 4.6 percentage points during the past year. The major reason for the recent acceleration in the price decline in Japan was the prices of imports such as resources and energy being lower than the high levels observed up until around the summer last year. From the autumn this year, the effects of higher prices of last year are expected to diminish gradually. Going forward, price developments will, in principle, be affected by the supply-demand balance of the economy as a whole. In that regard, if economic conditions recover in line with the projection that I have mentioned earlier, the supply-demand balance of the economy will improve gradually, and the year-on-year rate of decline in the CPI will likely moderate. However, the supply-demand balance has been deteriorating greatly, reflecting the sharp deterioration in economic conditions from the autumn of last year, and the pace of improvement in the supply-demand balance is expected to be slow, reflecting the aforementioned economic outlook. Therefore, the downward pressure on prices is likely to persist for a long period. The situation is the same in the United States and Europe, and the view is prevailing in many countries that it will take a considerable period of time for the growth rate of prices to return to a desirable level, while the level itself differs between countries. What is critical in the conduct of economic policy is whether there is a possibility of the price declines leading to a vicious circle that a decline in prices will induce a deterioration in economic conditions, which will in turn lead to a further decline in prices – the so-called deflationary spiral. To that end, there are two key factors for judgment. The first is whether the stability of the financial system is being maintained. Looking back in history the cases in which price declines caused a contraction in economic activity, most cases coincided with the period of significant financial system instability, as typified during the U.S. Great Depression in the 1930s. Japan's financial system has so far been generally stable, and in that regard the Bank does not judge that the risk of the economy falling into a deflationary spiral has increased. And the second is whether firms and households' inflation expectations in the medium to long term decline. Various survey results and market developments suggest that firms and households' expectations for inflation in the medium to long term have so far been stable. By also taking into account those points, the Bank has been closely monitoring price developments. IV. The Bank's thinking behind monetary policy conduct After having explained economic and price developments, I will lastly briefly refer to the Bank's conduct of monetary policy and the thinking behind it. I have explained the significant changes in the global economy since last year by summarizing the causes into two factors: the liquidity crisis and the balance sheet adjustments. When a great stress is imposed on financial markets, what a central bank should do as a top priority is to provide ample liquidity and ensure the stability of the financial markets and the financial system. To avoid the risk of the economy falling into a deflationary spiral, a central bank should properly and promptly act as "the guardian of liquidity." Meanwhile, it varies from country to country the extent to which the balance sheet adjustments by the private economic entities are needed. In any event, those adjustments are an inevitable process for the global economy to return to a sustainable growth path. The problem is that, if the pace of adjustments is too fast, economic activity will deteriorate further. In those circumstances, the role required of the policy authority of each country is to strike a delicate balance between encouraging necessary balance sheet adjustments to proceed smoothly, and preventing them from moving too rapidly so as to induce a further deterioration in economic conditions. Since last autumn the Bank has reduced the policy interest rate to 0.1 percent, and has taken various measures to ensure the stability of financial markets and facilitate corporate financing, including the U.S. dollar funds-supplying operations against pooled collateral, the outright purchases of CP and corporate bonds, and the special funds-supplying operations to facilitate corporate financing. In addition, by being particularly focused on maintaining the stability of the financial system, the Bank has also taken measures such as the purchase of stocks held by banks and the provision of subordinated loans to banks. While not a few of those measures have been extraordinary ones as policy instruments of a central bank, the Bank has judged it appropriate to carry them out as temporary measures in light of the difficult economic and financial situation. At present, Japan's economic conditions are showing some signs of recovery. At the same time, the Bank fully recognizes that the outlook is associated with great uncertainty. While there might be many possibilities, the Bank will pay attention for the time being to the downside risks to economic activity and prices, and continue to do its utmost as the central bank to bring Japan's economy back to a sustainable growth path with price stability. In the meantime, as for the treatment of temporary measures, the Bank will properly make decisions without a predetermined view upon thoroughly examining the state of corporate financing and financial markets. In closing, leaving the issues of monetary policy, I will emphasize the importance of the efforts to raise the productivity level of the economy as a whole. Needless to say, what determines the long-term growth path of a country's economy is an increase in the level of productivity. While Japan's ratio of business fixed investment relative to GDP is now at a high level among the advanced countries, when considered together with Japan's recent low growth rates, it suggests the low returns of domestic investment. The rise in the investment efficiency and the productivity level of the economy as a whole will be brought about by advancing the development of high value-added products as well as pursuing optimal resource allocation at various levels, including within firms, between firms, between industries, and between regions. The main characters that address the issue of raising productivity are of course people of the private firms. For such efforts, the Bank is and will be of service through creating a stable economic and financial environment. Thank you.
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Remarks by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at the Panel Session "Monetary Policy Boundaries: Alternative Instruments and Policy Coordination" at the Money & Banking Conf. 2009, CB of Argentina, Buenos Aires, 1 Sept. 2009.
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Kiyohiko G Nishimura: Unconventional policies of central banks – restoring market function and confidence Remarks by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at the Panel Session "Monetary Policy Boundaries: Alternative Instruments and Policy Coordination" at the Money and Banking Conference 2009, Central Bank of Argentina, Buenos Aires, 1 September 2009. * * * Thank you, Chairman. It is an honor to be invited to this prestigious conference, and I am very grateful to Governor Redrado and the colleagues of the Central Bank of Argentina. I am particularly delighted, literally thrilled, to come to Argentina, the land of silver and warmhearted people, for the first time in my life. The topic of this panel, "Monetary Policy Boundaries: Alternative Instruments and Policy Coordination" is particularly timely, since many central banks including the Bank of Japan have already crossed conventional boundaries. They have been conducting unconventional policies since the current crisis erupted a couple of years ago. Some call them credit easing, and others describe them as quantitative easing. This kind of nomenclature is eye-catching, but it is sometimes a distraction, hiding the real picture of what the central banks have done. In fact, if we look at these unconventional policies from a functional viewpoint, they all have this in common: the desire to counteract market dysfunction and confidence erosion. In this short presentation, I will first explain what we, the major central banks have done to prevent market meltdown. Then, from this experience, I will extract four practical principles of unconventional policies that should be borne in mind. Finally, based on these principles, I will point out possible fallacies in assessing these unconventional policies, especially at the time economic conditions improve and seem to offer a glimmer of light at the end of the tunnel. Specifically, I will present five Don’ts for your consideration in contemplating a way out from the emergency measures. 1. One prerequisite of conventional monetary policy: smoothly functioning financial markets To start the discussion of unconventional policies, it is worth taking a few moments to consider what conventional monetary policies are. Two pillars of smooth-functioning financial markets In a stylized framework of conventional monetary policies in developed countries, we take well-functioning financial markets for granted. There are two pillars supporting their smooth function. First, the various segments of the financial markets are integrated well through smooth inter-market arbitrage, and thus we have relatively stable inter-market relationships of interest rates called yield curves. Second, market participants have confidence in the markets and thus counterparty risks are contained well. Assuming these well-functioning financial markets, the central bank sets the policy rate at a level consistent with its stated goal of price stability (and possibly other goals which vary with countries). The bank manages its liquidity provision to ensure that short-term market interest rates are in line with the policy rate. The change in the policy rate affects the yield curve structure with term and risk premiums. In this way, the central bank affects financial markets and financial intermediation, and ultimately exerts influence on prices and economic activity. Thus, well-functioning financial markets are prerequisites of conventional monetary policy. In fact, the functional breakdown of financial markets is the major culprit leading central banks to take unconventional measures. We learned this fact from Japan’s so-called Lost Decade more than a decade ago and more strikingly, more painfully, from the current global financial turmoil. 1 Three phases of financial markets’ functional breakdown in the current crisis Let me briefly explain how markets stopped functioning in many countries in the current crisis. Roughly speaking, there were three phases, though their timing and severity were different from country to country. In the first phase, confidence in the markets was lost. The failure and the fear of failure of large international financial institutions made market participants fearful of the possibility of the failure of their counterparties. Counterparty risks were heightened and spread rapidly from market to market. In the second phase, we saw a severe dearth of arbitrage activities and consequent dislocations in many markets. Financial markets became severely segmented and some specific markets, such as the US assetbacked securities markets, collapsed. Prices no longer provided sufficient information about market conditions. In the third phase, severe strains on financial markets and banking systems hampered financial intermediation as the losses on non-performing, legacy or toxic assets mounted, and thus a negative feedback loop kicked in between financial strains and real economic slumps. In short, the conventional monetary transmission mechanism broke down. 2. Unconventional policies: coping with market dysfunction and confidence erosion Given the severe adverse effects of market dysfunctions, the utmost policy priority of central banks was to find a way to alleviate market dysfunctions and thus to enhance financial intermediation, thereby restoring the monetary transmission mechanism. This is what unconventional policies are all about. This means unconventional policies are not exotic but extensions of conventional policies. However, central banks had to go beyond their traditional role as a liquidity provider, and to engage themselves in complementing and enhancing market functions. 2 Central banks’ response to market dysfunction This was in fact what four major central banks (Fed, ECB, BOE, BOJ) and others did during the last two years in addition to a series of policy rate cuts down to the proximity to zero. Market dysfunctions and severe strains on a banking system significantly reduced the effectiveness of an ultra-low policy rate, which was evident in our experience of Japan’s lost decade. Thus, unconventional policies were devised and implemented essentially as measures to support and enhance the effects of ultra-low policy rates on prices and economic activities. First, in order to ease confidence erosion and tension in money markets, the central banks conducted ample and enhanced liquidity provision by offering more frequent operations, to For concise comparison of the two crises, see Nishimura, K. G., “ ‘The Past Does Not Repeat Itself, But It Rhymes’: Four Lessons Learned from the Financial Crises,” Remarks at the Panel Session “Responding to the Financial Crises: Lessons Learned” at the 45th Annual Conference on Bank Structure and Competition sponsored by the Federal Reserve Bank of Chicago on May 8, 2009, available on line at http://www.boj.or.jp/en/type/press/koen07/ko0905a.pdf. In other words, central banks had to act as a “plumber” to fix broken and clogged pipes to facilitate liquidity going through the system. See Shirakawa, M., “Financial System and Monetary Policy Implementation: Long and Winding Evolution in the Way of Thinking,” Opening Speech at 2009 International Conference hosted by the Institute for Monetary and Economic Studies, available on line at http://www.boj.or.jp/en/type/press/koen07/ko0905e.htm more counter parties, at longer maturities, and against broader collateral. This was more applicable to the period of August 2007 to August 2008. Then, as the erosion of confidence intensified after the failure of Lehman Brothers and market dysfunctions and financial distress became more pronounced, the central banks began intervening in specific market segments to support market functioning by measures including the introduction and expansion of asset purchase programs for commercial papers, corporate bonds and government debts. Also, the Fed expanded swap lines with other central banks to enable other central banks to provide further dollar liquidity. This was what largely took place in the period from September 2008 to March 2009. Currently conditions in money markets have improved and investors’ appetite for risk has recovered to some extent and accordingly usage of some market-supporting facilities such as the Fed’s and BOJ’s commercial paper programs has declined markedly. As an example of central bank policy actions in this financial crisis, I summarize what the BOJ did in the last two years in Chart 1. You can find a similar and sometimes longer list of policy actions at other central banks. Four practical principles to cope with market dysfunctions Unconventional policies entail microeconomic intervention and explicit risk-taking by central banks. Thus, these policies should satisfy two basic criteria. First, the benefits of market intervention should outweigh the costs of distorting resource allocation. Second, central banks should have a sufficient capital buffer of their own and appropriate burden-sharing agreements or understandings with the government to guard against possible credit losses. The latter is of the utmost importance to maintain central banks’ credibility in pursuing price stability. Besides these considerations, there were four practical principles in considering unconventional policies, which produced both differences and similarities among countries. Principle 1. Select and concentrate Although dysfunction was widespread, it was clear that no central bank had the operational capacity and capital buffer to intervene in all markets showing dysfunction. It was also evident that some markets were more important than others for the purpose of restoring the monetary transmission mechanism. Thus, the first practical principle is to select the most important markets and most cost-effective interventions, and to concentrate on them. In practice, this required cross-checking of bottom-up and top-down considerations. Bottom up, we started by examining the degree of dysfunction of particular financial markets, and then determined specific target segments of the markets for intervention. We worked out our specific intervention conditions and possible exit mechanisms. At the same time, top down, we carefully examined the pros and cons of allocative distortion, resource constraints and operational capabilities of the central bank, and capital constraint of the central bank if the intended measures exposed it to market and credit risks. The cross-checking of these two was particularly effective. The immediate corollary of this principle is that, firstly, the nature and the magnitude of a particular central bank’s market intervention depends on the nature and the magnitude of its country’s financial market breakdown, and secondly, the resulting increase in the balance sheet of a central bank differs considerably from country to country. Table 1 reports crosscountry differences in corporate finance. In the United States, securities markets were far more important than in Japan, and even financial institutions depend heavily on CP markets for their own finance. And the collapse of securities markets was widespread. Thus, the Fed was obliged to undertake massive and wide-ranging intervention. In contrast, the strain on the Japanese securities markets was mostly contained in CP and corporate bond markets, and we saw a relatively smooth transition from security market funding to bank borrowing. Consequently, the Bank of Japan’s market intervention was limited to CP and corporate bond markets, indirectly through the banking system, which was still functioning relatively well (Item 3 of Chart 1, measures to facilitate corporate financing). Consequently, the Fed’s increase in balance sheets is far greater than the Bank of Japan’s, which is depicted in Chart 2. Europe’s structure of corporate finance is closer to Japan’s, so the ECB’s increase in balance sheets was similar to the BOJ’s. Principle 2. Avoid further dysfunction When we are coping with market dysfunction in some markets, it is counterproductive to take action that undermines the functioning of other markets. That is, no policy measure should damage the incentive to trade actively in financial markets, especially if these markets’ full functioning is prerequisite for normalcy. The decision taken by many central banks to have a policy rate close to, but sufficiently above, zero is based on this consideration. 3 Principle 3. Provide safety nets The current financial crisis has shown how devastating the erosion of market confidence can be. When confidence is eroded, investors are “excessively” averse to uncertainty (or the socalled unknown unknowns), and become sensitive to any news having some bearing on the worst possible case scenario. 4 Actions that may be rational at the level of individual market participants can lead to a "fallacy of composition," which prevents the markets from restoring their functions. Even worse, functional breakdown and confidence erosion aggravate each other. In this respect, a safety-net facility, which works like a put option to mitigate damages that would be incurred in the worst possible case, is likely to reduce the degree of this “excessive uncertainty aversion.” The measures to secure stability of the financial system (Item 4 of Chart 1) were intended to be the safety-net measures we are discussing here. Japanese banks held sizable amounts of corporate stocks, which turned out to impose serious risks when stock prices went down sharply. The Bank of Japan resumed purchases of stock held by financial institutions and began to provide subordinated loans to banks. These were measures to help banks to reduce stockholding risk by selling their cross holding, and to improve their capital positions when they thought it was necessary. In addition, to some extent, ample liquidity provision (Item 2 of Chart 1) could also be considered as a form of safety net. Also, outright purchases of CP and Corporate Bonds from eligible financial institutions (in Item 3) had this safety-net feature. Similar safety-net measures were also found in many countries. 5 Principle 4. Design measures to be self-fading as conditions improve Unconventional policy measures entail possible side effects distorting resource allocation. They also impose financial risks and possibly reputation risks on central banks. Accordingly, these unconventional measures should be temporary and designed to unwind themselves as market functions improve. We describe measures with this inbuilt characteristic as selffading. If short-term rates are flatly zero, few have incentive to trade in short term financial markets, and thus there is no demand for traders. In this way, zero rates destroy the trading infrastructure including the know-how of traders. If a decision maker’s confidence is “contaminated” or eroded in the sense that she thinks, though with a small probability (say ε), she is ignorant about the situation she faces, her rational behavior can be described as “maximin” optimization. In the maximin optimization, she is particularly sensitive to the worst possible case scenario. See, Nishimura, K. G., and H. Ozaki (2006), “An Axiomatic Approach to ε-contamination,” Economic Theory, Vol. 27, 2006, pp. 333-340. The Fed’s TALF is one example having this feature. Some of the unconventional measures I have outlined have this characteristic. For example, the term of outright purchases of CP and corporate bonds is substantially higher than the “normal” one, though lower than that in distressed conditions. Therefore, as conditions improve, market participants find it unprofitable to use these facilities, as exemplified in the recent decline in the usage of these facilities. 3. Five don’ts in assessing unconventional policies Many of these unconventional policies are emergency measures: they are implemented as measures to enhance the effects of ultra-low policy rates on prices and economic activities under the condition of severe financial market dysfunctions. Thus, when market conditions improve, many of them will eventually be terminated. However, timing and sequencing are crucial: financial markets may still be severely segmented even though inter-market arbitrage starts again. Market participants’ confidence may be still fragile. In such circumstances, it is absolute necessity to avoid fallacies and misinterpretations with respect to assessing unconventional policies. I will present five Don’ts in order to avoid the fallacies which might otherwise mislead us. Don’t take the central bank’s balance sheets as a measure of monetary easing First, do not assume the size of the central bank’s balance sheets is indicative of the degree of monetary easing. Many unconventional policy measures are designed to be selective and are tailored to a specific market dysfunction. Thus, there is no common yardstick evaluating all market intervention. Moreover, the usage of unconventional policy facilities declines as market functions improve. Shrinkage of a central bank’s balance sheet reflecting this mechanism should not be interpreted as a monetary tightening but rather as a sign of improving market conditions. Don’t look only at the segments of financial markets subject to intervention Second, do not look at the conditions of only those segments of financial markets where intervention has taken place. In fact, there might be spill-over effects to other segments. Given resource and capital constraints, the central banks target their market interventions quite specifically. However, in so doing, central banks expect positive spill-over effects to other segments not so targeted. A good illustration of this lies in Japanese CP markets. We see improvements, as expected and hoped for, in the A2-rated CP market even though they are not eligible for the BOJ’s purchase program. The A2-rated CP market is apparently affected by our purchase of A1-rated CP. Don’t underestimate safety nets Third, do not underestimate the beneficial effects of safety-net measures especially when investors’ confidence is fragile. When market confidence is eroded, investors are “excessively” averse to uncertainty and tend to “wait and see” until they feel more confident about making market transactions. A “safety net” facility has some of the characteristics of insurance or put options and thus substantially reduces this sort of uncertainty. Just as insurance is an umbrella for unexpected rain, a safety net builds confidence whether or not dire events come to pass. An underutilized facility does not necessarily mean it is ineffective or useless. Don’t ignore heterogeneity among countries and regions Fourth, do not ignore heterogeneity among countries and regions. It is not the case that every country should follow a common sequence of policies to exit from unconventional policies. Economists, including me, have a tendency to ignore statutory differences and institutional subtleties among countries and regions, to get clear-cut empirical results and policy recommendations. There are always pitfalls in this tendency, which we should be very careful to avoid. At the outset of my presentation, I described a stylized framework of conventional monetary policy that assumed well-functioning financial markets. However, in fact, the description of well-functioning financial markets there is an idealized one, not always true even for developed countries. For example, Japanese financial markets experienced temporary segmentation in some segments from time to time even before the current crisis, and the BOJ conducted painstaking market operations. An immediate corollary of this is that an unconventional policy in one country is not necessarily unconventional in other countries. The outright purchase of government bonds is a case in point. The Fed stated the purpose of purchasing longer-term Treasury securities is “to help improve conditions in private credit markets” in March 2009; the BOE conducts its purchase of gilts as a means of “Quantitative Easing.” However, the BOJ has been conducting outright purchases of Japanese governments bonds as a traditional tool of market operation, to provide longer-term liquidity. Don’t assume a return to the way it was Now I come to the last of the five Don’ts: Do not assume we will return to “the way it was.” Although the collapse of the global financial markets took place in a surprisingly short period of time, their rebuilding and restructuring is likely to be a long and slow process. The “normalcy” to which we are returning is the one in which rebuilding and restructuring are still under way. Moreover, “the way it was,” that is, as financial markets were before the crisis, with high leverage and dubious securitized products, has been shown to be unsustainable. We live in a world of irreversibility, a world in which we cannot undo what we have done. Both financial markets and real economies have changed in an irreversible way. Now we have to be flexible enough to adjust ourselves to this changing reality. Thank you for your kind attention. (Chart 1) BOJ’s Policy Actions (Selected) 1. Reductions in policy interest rate 0.5% ⇒0.3% (Oct. 08)⇒0.1% ( Dec.08) 3. Measures to facilitate corporate financing • 2. Measures to ensure stability in financial markets • • • • • Introduction and expansion of US dollar fundssupplying operations (Sep, Oct. 08) Increase in outright purchases of JGBs 14.4 trillion yen/year⇒16.8 trillion yen/year (Dec. 08)⇒21.6 trillion yen/year (Mar. 09) Expansion of the JGB repo (Oct. 08) and securities lending facility (Oct. 08, Feb .09) Introduction of complementary deposit facility (Oct. 08) Broadening eligible collateral for funds supplying operations (Jan, Feb, Apr, May 09) • • • • 4. Measures to secure stability of financial system • * Funds-supplying operations by which the Bank extends loans to its counterparties for an unlimited amount against the value of corporate debt submitted to the Bank as collateral by them at an interest rate equivalent to the target for the uncollateralized overnight call rate. Increase in frequency and size of CP repo operations (Oct. 08) Introduction and expansion of special fundssupplying operations to facilitate corporate financing* (Dec. 08, Feb. 09) Introduction of outright purchases of CP from eligible financial institutions (Jan. 09) Introduction of outright purchases of corporate bonds from eligible financial institutions (Feb. 09) Expansion in the range of corporate debt as eligible collateral (Dec. 08) • Resumption of stock purchases held by financial institutions (Feb. 09) Provision of subordinated loans to banks (Apr. 09) (Chart 2) Central Banks’ Balance Sheets Jun. 2007=100 BOJ FRS ECB BOE Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Jul-09 (Table 1) Funding Sources of corporate finance (Amount outstanding, billion USD, End of 2007) CP, Bonds (A) Loans (B) Ratio (A/B) Japan 2,935 24% USA 3,872 2,937 132% Europe 1,015 10,995 9% UK 2,290 31% Sources: BOJ, FRB, ECB and ONS.
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Speech by Mr Hirohide Yamaguchi, Deputy Governor of the Bank of Japan, at the 4th Annual Euromoney Japan Capital Markets Congress, Tokyo, 18 September 2009.
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Hirohide Yamaguchi: Some remarks on the financial crisis over the past year Speech by Mr Hirohide Yamaguchi, Deputy Governor of the Bank of Japan, at the 4th Annual Euromoney Japan Capital Markets Congress, Tokyo, 18 September 2009. * * * Introduction I am honored to be invited to speak today at the fourth annual Euromoney Japan capital markets congress. The collapse of Lehman Brothers one year ago triggered unprecedented disruptions in the global financial markets. Fortunately, financial conditions have improved recently to a great extent, but they have not yet fully recovered from the crisis. Today, by looking back on the financial and economic developments in the past year, I will provide some of my impressions of those developments. I. Economic and financial developments after the collapse of Lehman Brothers The global financial markets changed drastically after the collapse of Lehman Brothers in September 2008. Market participants became increasingly cautious about taking counterparty risk, causing trading volume to decrease sharply and market liquidity to decline significantly. Credit spreads widened and the prices of financial products, including securitized products, plunged. Consequently, financial institutions experienced business difficulties or failed one after another in many countries, thereby aggravating financial system concern. Credit provisions from financial institutions to firms and households declined markedly, leading to a global credit contraction. Confidence, which is the most crucial element in the financial system and markets to function smoothly, was virtually lost. Meanwhile, economic conditions deteriorated simultaneously and rapidly around the globe. Final demand – namely, housing investment, private consumption, and business fixed investment – plunged, leading to large-scale adjustments in inventory and production. This deterioration in economic conditions, together with a spread of anxiety among firms and households, exacerbated the malfunctioning of the financial system, and in turn deteriorated economic conditions further, causing a downward spiral – the emergence of the so-called adverse feedback loop between financial and economic conditions. Also in Japan, the functioning of commercial paper and corporate bond markets was impaired, and strains in Japan’s short-term money markets increased as reflected in a rapid expansion of the LIBOR-OIS spreads. Nevertheless, the stress imposed on financial markets and the financial system in Japan after the collapse of Lehman Brothers was low relative to that in the United States and Europe because financial institutions in Japan had little exposure to securitized products. However, the slowdown in economic growth was rapid in Japan, compared with that in the United States and Europe. Against a backdrop of a global accumulation of inventories of durable and capital goods and the ensuing large-scale reduction in production to adjust the level of inventories, exports of automobiles, electrical machinery, and general machinery – industries in which Japan excels – declined in an unprecedented manner. Accordingly, production declined considerably. The factor behind the sudden contraction of financial and economic activities on a global basis, including Japan, was an accumulation of various excesses during the mid-2000s, particularly in the United States and Europe, and the adjustments of the balance sheets of firms and households emerged in the process of the unwinding of excesses. During the mid2000s, the world economy constantly registered unprecedented high levels of growth at around five percent. Despite this high growth rate, prices continued to be generally stable, and accommodative financial conditions continued for a long time around the world. The continued benign environment of high growth, low inflation, and accommodative financial conditions led to the prevalence of optimism for the future (which in retrospect is hard to believe). Meanwhile, overconfidence also spread in the sophistication of financial technologies that were developing remarkably at the time. In those circumstances, imbalances such as the increase in credit and leverage as well as the rise in asset prices accumulated worldwide. Developments since last autumn can be described as essentially the adjustment of the accumulated imbalances; in other words, the bursting of a global credit bubble. Nevertheless, world economic conditions have been showing signs of leveling-out since the spring of this year. That is because the global financial markets have gradually started to stabilize because the provision of ample liquidity by central banks around the world, the aggressive public capital infusion and debt guarantees by the governments for U.S. and European financial institutions, have dissipated market participants’ extreme anxiety. The progress with inventory adjustments on a global basis due to large reduction in production, and the manifestation of the effects of large-scale economic stimulus measures implemented around the globe have also contributed. Thanks to such developments, a positive trend has been emerging in Japan's economy. Exports and production have been recovering, especially in the automotive and electronic parts industries. Fiscal measures including public investment have also been underpinning economic activity. As for the economic outlook, the upward momentum in the world economy is likely to continue for a while. The recent clear recovery of emerging economies is a reassuring factor. Against this background, Japan's economy is expected to start recovering from the second half of Japanese fiscal 2009. Of course, as I have previously mentioned, the world’s firms and households are now in the process of balance sheet adjustments. Therefore, the momentum for recovery in the world economy greatly depends on how the balance-sheet adjustments evolve, and Japan will not be immune from the influence of such developments. Consequently, there still will be considerable uncertainty about the outlook. The Bank of Japan, paying due attention to various risk factors, will continue to monitor carefully financial and economic developments both at home and abroad. II. Some remarks After confirming the current financial crisis and large swings in economic activity, I have come up with several impressions or questions. First, how effective is the advancement of financial technologies in controlling risk? Second, how to solve the issue that prolonged benign market conditions can actually encourage economic entities and market participants to engage in excessive action, and thus might just lead to future large swings in the economy. Third, is it possible to maintain high market liquidity even under any type of shock? And fourth, how market participants' extreme anxiety can be controlled? All of those questions are difficult to answer. Today, I will outline my thoughts on the first two interconnected questions as a basis for your discussion. Financial technology advancement and risk control – the importance of “self discipline” To begin with, let us consider if the advancement of financial technologies is effective in controlling risk, or has the experience of the current financial crisis proven it to be ineffective. Financial engineering, which has evolved rapidly in recent years, was first developed as a technique to control risks, that is, to break down and manage risks associated with financial products. Indeed, the advancement of financial technologies has made it possible to design a variety of financial products according to the specific risk preference of various investors, and, as a result, financial markets have become broader and more versatile. Securitized products, which triggered the current financial crisis, included various innovations to control the risks associated with normal lending and securities investment. For example, the bankruptcy remoteness of cash flows obtained from underlying assets as well as the creation of a risk buffer by setting multiple tranches enhanced the safety of investments and facilitated credit risk transfers. In addition, credit default swap transactions also allowed easy credit risk transfers. These methods were believed to be capable of controlling accurately the risks associated with securitized products. However, the reality was different. As turmoil actually occurred, massive risks surfaced, and it became clear that the methodology of risk control initially envisaged did not work. Importantly, the root of the problem in fact lay in the loose assessment of simple risk factors, rather than the complex technology of securitization itself. Specifically, the basic standards of risk management, such as the credit risk of the original debtor, risk monitoring, liquidity risk of investment vehicles, and the degree of correlation between the risk factors, were neglected. In addition, we should not forget that there was a lack of preparedness for the tail risks that occurred when great stress was imposed on the financial markets. If we consider the foregoing, the heart of the problem can be attributable to two elements: lax risk assessment due to a behavioral pattern of market participants who put the pursuit of profit first, and the so-called agency problem based on information asymmetry. Of course, the resolution of the problem is not easy. Strengthening of regulations and introduction of further advanced financial technology cannot control all the risks nor completely resolve the agency problem. In addition, as long as the pursuit of profit is a basic incentive for market participants, lax risk assessment under certain market conditions might result from human nature. While I do not deny the importance of enhancing risk management through the advancement of financial technology, it is perhaps difficult to control human nature and psychology with financial technology. What is of the utmost importance is for market participants to avoid a deep sense of complacency in relying on financial technology for risk management, and to remain vigilant in maintaining the crucial risk awareness, that is known as “self-discipline”. In my view, the unsolved part of uncontrollable risks and agency problems might be somewhat solved by this “self-discipline”. We need to recognize again that regulations and advanced financial technology are not a substitute for “self-discipline”. In that regard, future financial supervision and regulation that are currently being discussed on a global basis, should be carefully crafted from the viewpoint of whether they would function to strengthen the internal “self-discipline” of market participants, rather than merely being an externally imposed compliance regime. Preempting excessive behavior of market participants – the sharing of “common sense” I will now turn to the issue of whether there are ways to preempt the excessive behavior of economic entities and market participants. As previously mentioned, the current financial crisis grew out of the need for an adjustment of the imbalances that accumulated through the mid-2000s. The creation of financial and economic excesses and their eventual adjustment is a cycle that has been repeated over and over around the world. In each of those cases, the causes and preventive measures were seriously discussed, and necessary improvements were made in terms of system and regulation. Despite those efforts, we have allowed again the accumulation of imbalances and the occurrence of a financial crisis. Why excessive financial and economic activities recur? It might be true that humans by nature cannot learn from history. It seems that each time a state of benign economy continued for a long time, plausible logic appeared to explain that “this time was different”. The examples include: “Tokyo is becoming a global financial center” used during the Japanese bubble of the 1990s, and the “advent of a new economy” used in the case of the dot com bubble in the US; those examples go on and on. Each time it was extremely difficult to counter the new logic by merely relying on the lessons from history. Nonetheless, it would also be excessive to lay the onus solely on uncontrollable human nature. To come closer to the heart of the problem, we need to focus on the market participants' incentives under a capitalist economic system. Market participants pursue their own profits as their number one priority, and are not usually interested in how their actions influence the performance of the market as a whole and eventually the performance of the economy as a whole. Even if those actions result in an accumulation of excesses in the economy and cause considerable economic fluctuations when the excesses are eventually adjusted, those actions are deemed rational, at least in the short term, as long as the individual market participants make profits. On the other hand, for the authorities in charge of setting policy, they do not arrest individual market participants' pursuit of profit. Their main incentive is to improve the performance of the economy as a whole. The incentives of individual market participants and those of the policy authorities may conflict in the short run, but should be compatible over a longer period. Therefore, what becomes important is how to align the incentives on both sides over a longer perspective and to have this alignment reflected in the actions of both the actual market participants and the policy authorities. Here again, it is not easy to give a correct answer. Nevertheless, in my view, if the lessons learned from the past financial crises could be shared broadly between the policy authorities and market participants as one form of “common sense”, it might change the nature of incentives and could reduce the excessive actions of market participants. When I say “the lessons”, they are not such dramatic ones. It can be as simple as “when benign financial and economic conditions continue for a long time, there is a possibility that various excesses will accumulate, resulting in extremely large economic fluctuations.” Of course, it is easy to anticipate that there will be difficulties in utilizing the lessons, or “common sense”, in actual policy responses. However, whether such “common sense” is shared broadly or not could make a big difference in the economic outcome. Recently, the idea of macro-prudence has been discussed as a methodology for crisis prevention. While specific system designing is a future challenge, I believe that the sharing of “common sense” between the policy authorities and the market participants could be a starting point for the discussion of establishing a macro-prudence system. By occasionally reminding ourselves of the lessons from the financial crises and sharing the lessons as “common sense” with many people, we will ensure the flexibility of policy management and minimize the possibility of a future financial crisis. The Bank of Japan's measures to facilitate corporate financing In closing, turning to a different issue, I will briefly touch on the specific steps the Bank has taken since last year to facilitate corporate financing. In response to the substantial deterioration in corporate financing since the autumn of last year, the Bank has been taking a series of steps such as outright purchases of commercial paper and corporate bonds and special funds-supplying operations to facilitate corporate financing. While those measures were extraordinary as a central bank's policy measures, we judged it appropriate as temporary measures in light of the severe economic and financial conditions. As for how to treat those temporary measures, the Bank will decide by thoroughly examining the state of corporate financing and financial markets and considering the degree of their improvements. In doing so, a risk that the prolonged usage of temporary measures might impair an autonomous recovery in market functioning and result in a distortion of resource allocation, will also be taken into account. If the Bank can share such a risk as “common sense” with market participants, the Bank can conduct its policies in a timely manner. In addition, the incentives of the market participants and those of the policy authorities could be aligned in the context of achieving stable economic and financial conditions from a longer term perspective. Thank you.
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Speech by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at a Meeting with Business Leaders, Hyogo, 21 October 2009.
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Kiyohiko G Nishimura: Recent economic and financial developments and the conduct of monetary policy Speech by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at a Meeting with Business Leaders, Hyogo, 21 October 2009. * * * Introduction I am pleased to be here today to speak before, and exchange views with, distinguished business leaders of the economy of Hyogo Prefecture. Occasions like this are particularly valuable because they allow us to hear directly and in detail from businesspeople about the situation of the regional economy – including business conditions of many firms ranging from small to large – as well as provide our explanations, and hear your opinions, on the Bank of Japan's current outlook for the Japanese economy and its thinking behind the conduct of monetary policy. I understand that members of our staff, including the General Manager of the Kobe Branch, visit you frequently to collect information on economic and financial conditions of the region. The information you provide us is very important as a means of accurately understanding the economic and financial situation, and of formulating the conduct of monetary policy. I would like to take this opportunity to thank you for your cooperation. Today, before exchanging views with you, I would first like to explain the Bank's view on Japan's economic and financial situation, as well as its thinking behind the conduct of monetary policy. I will start with developments in the world economy and then move on to economic activity, financial conditions, and price developments in Japan. In view of these issues, I will briefly explain the Bank's thinking behind the conduct of monetary policy, and lastly express some of my views on medium- to long-term issues that the Japanese economy now faces. I. Developments in the world economy I would like to start with developments in the world economy. Until around the mid-2000s, the world economy enjoyed high levels of growth, at around 5 percent, with the innovation in information and communications technology and further globalization as the two main engines of growth. However, in hindsight, the rapid growth in the world economy, particularly in the United States and Europe, relied heavily on another factor: the optimistic expectations that prices of assets such as homes and stocks would continue to rise. Based on such expectations, households and firms aggressively increased their debt in favor of consumption and investment, while financial institutions increased provision of loans and consequently their leverage – the ratio of total assets to capital bases. The development of securitized products spurred this buoyant mood. 1 Securitized products are designed to transfer the credit risk associated with the loans extended by financial institutions to investors who have a higher capability than financial institutions to take on the risk. This allowed lower-income households that previously had been unable to afford to buy homes to become capable of making such purchases. At the same time, massive funds from investors, who sought higher returns without sufficient risk management, flowed into the securitized markets, thereby creating an overheating of the housing market. However, after For details on the role of securitized products, see "Financial System Stability and Market Confidence," a summary of a speech given by Kiyohiko G. Nishimura at the Japan Society of Monetary Economics' Spring Annual Meeting on May 16, 2009 (available on the Bank's web site at http://www.boj.or.jp/en/index.htm). home prices began to fall, the risks that investors had previously ignored came to the fore; this triggered the worsening of the U.S. subprime mortgage problem in summer 2007 and the subsequent asset bubble burst, which in turn led the world economy into severe recession from 2008. As a result, households and firms, as well as financial institutions, particularly in advanced economies, came to face the problem of balance-sheet adjustments: households and firms had to repay their excessive debt by curtailing their consumption and investment, while financial institutions had to dispose of their impaired loans and reduce their excessive leverage. The bursting of the asset bubble and ensuing increase in impaired assets at banks evolved into a financial crisis when Lehman Brothers collapsed last autumn. Providers of funds became extremely cautious about counterparties' creditworthiness. This led to a sharp decline in transactions in the interbank market, where banks lend and borrow funds, as well as in the corporate bond and CP markets, where firms raise funds, and financial markets ultimately stopped functioning. The sharp deterioration in market functioning, together with firms' and households' excessively heightened anxiety, shrank global financial and economic activity, creating acute pain for the world economy. Such pain began to wear off from around this spring, and global economic conditions have recently been improving for the following three reasons. First, the supply of ample liquidity by central banks, together with governments' measures to restore financial system stability, has proved effective, and global financial markets have been regaining stability. Second, inventory adjustments have progressed markedly as a result of a substantial production cutback worldwide. And third, the effects of macroeconomic policies implemented aggressively around the globe have begun to appear. In this situation, divergence and even polarization between sectors, as well as regions, have become evident all over the world. This trend can be observed widely in terms of both economic and financial activity. Let me give you four examples. First, production has recovered relatively quickly because of the progress in inventory adjustments, whereas recovery in employment conditions has been only very moderate. Second, developments in production and consumption differ greatly between sectors that are more influenced by the effects of fiscal policies and those that are less influenced. Third, a significant difference in the pace of recovery has been observed between advanced economies – which face the problems of balance-sheet adjustments following the collapse of the asset bubble and of an aging population – and emerging economies – which face neither of these problems. And fourth, in financial markets, the recovery in money markets has become clear, whereas in the longer-term markets, market liquidity still cannot be judged to have fully recovered, as seen in large differences in interest rates between borrower banks. The outlook for the world economy greatly depends on how the divergence and polarization will diminish, or, conversely, will intensify. The Bank's current baseline scenario for the world economy is as follows: emerging economies will first pick up, partly due to the policy effects; this upturn will exert positive effects on advanced economies, where private demand will start to improve gradually by the time the policy effects dissipate; and the world economy as a whole will eventually return to a moderate growth path. However, since the world economy may unfold a different scenario depending on how divergence and polarization evolve, the outlook is still attended by a high level of uncertainty. For instance, if the balance-sheet adjustments lead to a protraction of the serious employment situation in advanced economies, thereby restraining growth in demand, world economic growth could turn out to be weaker than projected. Should growth in emerging economies exceed expectations, world economic growth could also beat assumptions. If this is the case, demand for resources might increase and the terms of trade for advanced economies could deteriorate as commodity prices surge. Ultimately, advanced economies may fall into stagflation. I therefore believe attention should continue to be paid to how the various types of divergence and polarization evolve. II. Japan's economic developments I would now like to turn to Japan's economic developments. In recent years, the Japanese economy greatly depended on growth in overseas economies. Specifically, the driving force behind Japan's longest period of post-war economic expansion, which continued until the recent financial crisis emerged, was the growth in exports. Meanwhile, private consumption remained weak due to the change in the consumption structure associated with the further aging of the population, the low growth in domestic employment reflecting the transfer of production bases overseas, and the ensuing sluggish growth in household income. Such weakness in private consumption led to sluggish growth in business fixed investment of the industries dependant on growth in consumption, and domestic private demand consequently continued to be relatively weak. Furthermore, the sharp deterioration in global economic conditions – the situation that can be expressed as the acute pain caused by the recent financial crisis – led to a sharp contraction in the volume of world trade; this significantly reduced Japan's exports, and the country's economy underwent a sharp downturn at an unprecedentedly fast pace. However, positive momentum has been observed in Japan since this spring as overseas economic conditions have stopped worsening, and the Bank's current assessment is that "Japan's economy has started to pick up." Specifically, public investment, exports, and production have been increasing. On the other hand, against the backdrop of the severe income situation and weak corporate profits, private consumption and business fixed investment have remained relatively weak. For the time being, the future course of the Japanese economy will depend greatly on overseas economic conditions, and, as I mentioned earlier, these are expected to continue to recover, albeit at a moderate pace. Exports and production are expected to continue increasing. Public investment is also expected to keep rising for the time being, owing to progress in the implementation of the policy package. A recovery in corporate profits reflecting improvement on both the supply and demand fronts, as well as the implementation of various economic stimulus measures, is projected to gradually boost business fixed investment and private consumption, both of which have been relatively weak recently. In sum, the Bank's baseline scenario is that Japan's economic conditions are likely to improve gradually. However, the outlook is still attended by a high level of uncertainty. Needless to say, the most considerable risk factor behind the outlook is future developments in overseas economies; as I mentioned earlier, these pose upside as well as downside risks to the Japanese economy. In addition, domestic risk factors include a potential decline in firms' medium- to long-term growth expectations against the backdrop of domestic and overseas economic growth declining to a level lower than that realized before the current recession. As you can see, there are various risks to the outlook for the Japanese economy both on the upside and downside. On balance, the Bank's present assessment is that risks to the economy still remain greatly on the downside. In either case, the Bank will continue to carefully examine economic developments, while paying due attention to various risks surrounding the economy. III. Developments in the financial environment In parallel with the pickup in the Japanese economy that I have just explained, the financial environment, with some lingering severity, has increasingly been showing signs of improvement. I would now like to explain in some detail developments in Japan's financial environment since last autumn. In Japan, the acute pain caused by the financial crisis emerged markedly last autumn in securities markets such as the corporate bond and CP markets, in which large firms, banks, and institutional investors are major participants. After the collapse of Lehman Brothers, Japan's stock prices fell sharply and defaults of corporate bonds started to be observed. In these circumstances, the excessive anxiety of market participants prevailed in the corporate bond and CP markets, and this made investors excessively cautious about taking on issuers' credit risk. In addition, market functioning deteriorated significantly: transactions decreased sharply, and the average market rates did not reflect the market fundamentals but rather were influenced strongly by specific circumstances of individual transactions. As a result, conditions for corporate bonds and CP issuance deteriorated significantly. In the corporate bond market, the credit spread (the yield differential between corporate bonds and government bonds) on BBB-rated corporate bonds was at around 1 percent in summer 2008 but expanded rapidly thereafter, and exceeded 4 percent around the end of fiscal 2008. In fact, almost no issuance of BBB-rated bonds was observed at the time. Even the spread on A-rated corporate bonds, which have been recognized as medium-rated bonds, expanded and exceeded 1.5 percent around the end of fiscal 2008, although it was at about 0.7-0.8 percent in summer 2008. There was almost no issuance of such bonds from October through November 2008. Issuance rates on CP also rose substantially. In November, CP issuance rates (3-month) exceeded banks' lending rates (in terms of the average contracted interest rates on new short-term loans) for the first time, although this entirely unprecedented phenomenon was observed only in this month. Accordingly, large firms, which faced difficulty in raising funds by issuing corporate bonds or CP, began to shift to bank loans to satisfy their funding needs. Large firms' shift to bank loans reduced the flow of funds into small firms, raising concerns about small firms' cash availability. In this situation, large and small firms came to see their financial positions as having deteriorated substantially, and around the end of fiscal 2008 the judgment index worsened to the level observed at the time of Japan's financial crisis in 1998. Tensions intensified not only in securities markets but also in bank loan markets, and this caused concerns about a potential adverse feedback loop between financial and economic activity, whereby deterioration in financial activity worsens economic activity, and financial and economic activity amplify the adverse effects on each other. Thus, Japan's financial environment worsened significantly, particularly in the area of corporate financing, creating a situation that I expressed as acute pain caused by the financial crisis. Recently, however, as excessive anxiety in financial markets has subsided and economic activity has started to pick up, the financial environment has increasingly been showing signs of improvement, although there remains some lingering severity for small firms in particular. Let me discuss recent developments in securities markets, focusing on the changes from the conditions that I mentioned earlier. Conditions for corporate bonds and CP issuance, which had been worsening and consequently exerting pressure on large firms' funding, have recently become favorable, except for corporate bonds that are rated BBB or lower. 2 The credit spread on A-rated corporate bonds has declined since around this spring, and the value of corporate bonds issued publicly has increased markedly. The number of firms issuing bonds has also increased. There are even some market participants who have recently pointed out some overheating of the markets. In contrast, while public issuance of BBB-rated corporate bonds has been observed, the number of firms issuing such bonds is limited as the credit spread remains at a high level. However, the unfavorable conditions for issuance of low-rated bonds seem to be due to structural factors, rather than the market According to the September Tankan (Short-Term Economic Survey of Enterprises in Japan), CP issuance conditions as perceived by firms of all industries have improved only marginally. This seems to represent a bias in the results since some firms that do not issue any CP responded to the question based on, for example, media reports. In fact, looking at the figures by industry, CP issuance conditions as perceived by firms of industries that include many CP issuing firms have improved greatly. dysfunction; in fact, investors have attributed the continued sluggishness in the issuance of low-rated bonds to the rekindling of concerns about possible downgrading of issuing firms, while issuing firms have attributed it to the fact that the terms for bank loans are more appealing than those for funding in the corporate bond and CP markets. Regarding the CP market, the issuance rates have declined significantly regardless of credit ratings, and those of high-rated CP have even fallen below yields on government bills. As for changes in bank loan markets, firms' demands for loans to fund working capital and fixed investment have declined recently. In fact, the diffusion index for financial institutions' perception of demand for loans in the Senior Loan Officer Opinion Survey on Bank Lending Practices at Large Japanese Banks recorded the highest figure at the end of last year, then peaked out, and became negative in the July survey regardless of the firm size. Against such a backdrop, the pace of increase in bank lending, after showing high growth on the back of the sharp economic downturn until around the end of 2008, has been slowing. Since the economy has started to pick up and the functioning of securities markets has been improving, large firms have come to see their financial positions as having improved markedly. Small firms also have reported that there are signs of improvement, partly because the effects of the emergency guarantee scheme, introduced by the government at the end of last year, have begun to appear and partly because the economy has started to pick up. However, there remains some lingering severity, as shown by the fact that the level of the judgment index is still around that observed at the time of the bottom of the economic cycle in early 2002, and that the extent of improvement is marginal compared with large firms. IV. Developments in prices I would now like to discuss developments in prices. Consumer prices have shown large swings since last year, reflecting changes in the prices of petroleum products. More specifically, on the back of the surge in the prices of petroleum products, the year-on-year rate of change in the consumer price index (CPI; excluding fresh food) rose sharply in the first half of 2008 and posted an increase of 2.4 percent in the summer of that year. It was the highest rate in about 16 years, since 1992, excluding the year when the CPI was impacted by a rise in the consumption tax rate. However, after the rapid increase, it started to decline significantly from the second half of 2008. The latest data released at the end of September showed that the CPI declined by a year-on-year rate of 2.4 percent in August, marking the largest drop since the data began to be compiled. The level of the CPI in August is equivalent to the level in June 2007, just before the period when the prices of petroleum products began to surge. As for the outlook, the year-on-year decline in the CPI is likely to moderate as the effects of the prices of petroleum products abate and the supply-demand balance improves as a result of the pickup in the economy. Nevertheless, the year-on-year decline in the CPI is likely to continue for a relatively long time, because substantial slack seems to have emerged in the economy due to the significant economic downturn from autumn 2008 and because the pace of improvement in the supply-demand balance is expected to be slow. I would like to note that not only Japan but also many other major economies, including the United States, are seeing a downward trend in consumer prices. In many of these economies, while economic conditions are likely to improve, it is expected that it will take a long time for inflation rates to return to desirable levels given the significant impact of the negative demand shock to these economies. Against this background, the media seem to be citing the word "deflation" more frequently than before. "Deflation" is a common word but its meaning varies depending on the speaker. For instance, some use this word to mean a decline in consumer prices, whereas others use it to mean a decline in asset prices and in economic activity. Moreover, the price indicator they refer to varies and there is no consensus view about the degree and duration of a price fall to determine "deflation." Regardless of the definition of "deflation," a matter of great importance is whether there are prospects for the economy to return to a sustainable growth path with price stability. In this regard, it is important to prevent a situation where a decline in prices induces deterioration in economic conditions. To this end, it seems vital that the following two preconditions are met. First, financial system stability must be maintained. In a situation where the financial system is working properly, financial institutions can, to the extent depending on their financial soundness, provide liquidity to firms that faced a temporary, sharp fall in demand. If bank lending can act as a buffer to absorb a negative demand shock, firms are less likely to engage in fire sales to obtain funds to repay debt or engage in the sort of drastic reduction in prices that may lead to further deterioration in the economy. And second, it is essential that expectations for inflation rates over the medium to long term remain stable, uninfluenced by short-term developments in inflation rates. In such a situation, firms' price-setting behavior will probably be based on expectations that in the long run prices in general will turn upward. This is likely to prevent prices from declining continuously and reduce the possibility of further economic deterioration. I would now like to assess the environment surrounding prices in Japan on the basis of the two preconditions I just described. Regarding financial system stability, the Japanese financial system has not suffered from internal factors, such as impaired assets at Japanese banks, compared to the U.S. and European counterparts. As for expectations for inflation rates over the medium to long term, survey results and various market data suggest that there has been no notable change. Nevertheless, as balance-sheet adjustments are still continuing on a global basis, resultant risks to financial system stability are unlikely to disappear in the near future. Moreover, given that prices are expected to continue falling for a relatively long time, there remains a risk that expectations for inflation rates over the medium to long term could possibly decrease significantly in line with developments in actual inflation rates. Therefore, the Bank intends to continue to monitor developments in prices closely, while paying careful attention to the preconditions I have mentioned. V. Conduct of monetary policy by the Bank I have explained economic and price developments at home and abroad, and now would like to briefly talk about the Bank's thinking behind its current and future conduct of monetary policy based on these developments. Since last autumn, the Bank has conducted various measures to support the Japanese economy from the financial side. With regard to the interest rate policy, the Bank, after reducing its policy interest rate to 0.1 percent, maintained its extremely low policy interest rate level and thus provided an accommodative financial environment, contributing to underpinning economic activity. In addition, with a view to ensuring the stability of financial markets and facilitating corporate financing, the Bank, while providing ample liquidity to the markets, introduced measures such as outright purchases of CP and corporate bonds as well as special funds-supplying operations to facilitate corporate financing. Although it is extraordinary for a central bank to use many of these policy tools, the Bank judged it appropriate to introduce them as temporary measures in response to various phenomena such as the spread of excessive anxiety among market participants and the rapid deterioration in market functioning in the corporate bond and CP markets – acute pain in the financial environment caused by the recent financial crisis. Regarding the impact of these temporary measures, I believe that the outright purchases of CP and corporate bonds have proved effective to a certain degree in reducing excessive anxiety among market participants, and that special funds-supplying operations to facilitate corporate financing have supported the recovery in market functioning, which previously declined sharply. Also, I believe that the expansion in the range of collateral that the Bank accepts has boosted supply of credit by banks to firms. With regard to the policy measures taken in the recent financial crisis around the world, including those taken by the Bank, the term "exit strategies" has been frequently mentioned, as global economic conditions have started to improve. Exit strategies are variously defined but are often discussed at international conferences to indicate strategies to exit from expansionary monetary and fiscal policies as well as measures to stabilize financial systems. On this point, it was confirmed at the meeting of the Group of Twenty (G-20) Finance Ministers and Central Bank Governors held last month that, although "the . . . timing and sequencing of actions will vary across countries and across the types of policy measures," they "will continue to implement . . . necessary financial support measures and expansionary monetary and fiscal policies . . . until recovery is secured." This view was shared again at the meeting of the Group of Seven (G-7) Finance Ministers and Central Bank Governors held on October 3, 2009. In fact, it will take a long time for various adjustments to progress in the United States and Europe, and during the adjustment process expansionary policies will continue to be required in order to underpin economic activity. The Japanese economy has just started to pick up, and on the monetary policy front it is vital that the Bank secure the accommodative financial environment for an extended period to facilitate the return of the economy to a sustainable growth path. As for the emergency measures that have been introduced in response to the acute pain triggered by the collapse of Lehman Brothers, and in particular to the spread of excessive anxiety among market participants and the rapid deterioration in market functioning, the review of these measures should be separated from exit strategies regarding the macroeconomic policies that I have just mentioned. It is considered appropriate that the emergency measures be reviewed in accordance with the degree of decrease in excessive anxiety and of recovery in market functioning. In the United States, the Federal Reserve has already set out a plan to suspend or scale back some of its facilities such as purchases of long-term government bonds and the Term Auction Facility (TAF), which is a tool to supply longer-term liquidity. Regarding when the Bank's temporary measures should be withdrawn, the Bank will examine the impact and necessity of each measure as comprehensively as possible, and will make a decision at an appropriate time at a future Monetary Policy Meeting based on the comprehensive review. The Bank will continue to exert its utmost efforts as the central bank to facilitate the return of the Japanese economy to a sustainable growth path with price stability. Closing remarks: medium- to long-term issues that the Japanese economy faces In closing my speech, I would like to touch upon medium- to long-term issues that the Japanese economy faces. For the Japanese economy to attain growth that raises people's standard of living amid drastic changes in the world economy, Japanese firms need to address medium- to longterm changes in the world economic environment. I would like to point out three key changes. The first change, potentially, is a decline in the sustainable growth rate of the world economy. As mentioned earlier, given that the asset bubble lasted for a long time and spread globally, we may have to wait for some time longer than a typical short-term business cycle until the necessary adjustments are completed. Firms need to respond to this possibility from a longterm perspective. The second change is the aging of the population, which is developing in every advanced economy including Japan. In an economy where the population is decreasing due to aging, growth in consumption will inevitably slow and the structure of consumption will also change, with the relative importance of consumption by the elderly rising. China, which is enjoying high growth, is also likely to become subject to the effects of an aging population before long, although this issue is seldom discussed. The third change is tighter constraints from limited irreproducible resources and the ecological environment. Global warming is not an issue for a single country but literally for the entire globe. I believe the wisdom of corporate managers – today's main audience – can produce the best solution to deal with these changes. Therefore, I would like to raise only two general points. The first relates to how to address balance-sheet adjustments on a global scale. The importance of expanding domestic demand is undeniable, but I think it is also important to attract demand from emerging economies. They are Japan's competitors in world trade but at the same time potential customers for Japanese products. Historically, Japanese manufacturers have responded swiftly to structural changes in the world economy and cultivated new customers. I believe that they should further develop such competency to address the medium- to long-term issues, and this would be one of the pillars supporting a smooth adjustment process for the Japanese economy. The second point relates to how to minimize the negative effects of an aging population and the constraints from limited irreproducible resources and the ecological environment. My opinion is that innovations that create eco-friendly products will pave the road to success. Let me adduce an example of the issue of an aging population. Today's development of technologies, typically of digital appliances, seems to be one that primarily targets the younger generation and generates profits through mass production. However, such development would produce less value-added than before as the proportion of the population comprised by the younger generation decreases. It will become increasingly important for firms to employ new elderly-oriented technology ahead of their competitors. In fact, in the area of finance, product innovations are necessary to find the way to finance sociallyrequired investments by making use of financial assets held by the elderly in particular. It is crucial that different industries – for example, financial and manufacturing sectors – cooperate with each other to address such issues. Looking at the economy of Hyogo Prefecture based on the argument just presented, responses to the medium- to long-term changes in the economic environment seem to be making steady progress. As for responses to the constraints from limited irreproducible resources and the ecological environment, for example, there are many factories producing solar, lithium-ion, or nickel-hydrogen batteries in the region. A number of firms related to wind power generation are also clustered in Hyogo Prefecture, and I understand it is viewed as one of the regions with high potential in ecological business. The changes we are facing in the economic environment are a global phenomenon and eventually will affect all of society. In such a situation, exerting originality and ingenuity is the only way to survive as individual firms and a nation as a whole. I sincerely hope that various efforts currently being made will bear fruit and bring prosperity to the economy of Hyogo Prefecture.
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bank of japan
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Remarks by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at the Panel Session "The Repositioned Role of Central Banks in Today's Economic Environment" at the CME Group's Global Financial Leadership Conference, Tokyo, 2 November 2009.
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Kiyohiko G Nishimura: Unconventional policies against fear of “unknown unknowns” Remarks by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at the Panel Session "The Repositioned Role of Central Banks in Today's Economic Environment" at the CME Group’s Global Financial Leadership Conference, Tokyo, 2 November 2009. * * * First, I would like to take this opportunity to briefly comment on the unconventional policies 1 of central banks and their gradual wind-down. Aggravator of the global financial crisis: fear of “unknown unknowns” I would like to remind you of what aggravated and transformed a peripheral U.S. subprime mortgage problem into a full-blown global crisis: Namely, the contagious erosion of confidence, or the fear of “unknown unknowns” in financial markets. Market participants become excessively fearful that they might be confronting a previously unknown, essentially uncertain and unpredictable world. They assume the most pessimistic scenario possible and try to make the most of it. 2 What is more, market participants tend to stand on the sidelines until market confidence has been restored. The failure and the fear of failure of large international financial institutions caused market participants to be fearful of the possibility of the failure of their counterparties. Haircuts for the collateral rose rapidly and financial institutions were obliged to sell their assets at distressed prices to obtain immediate liquidity. Financial markets became severely segmented and some literally collapsed. Central banks’ policy responses: “catastrophe insurance” provider In order to address this problem, the central banks of developed countries first conducted ample and enhanced liquidity provision by offering more frequent operations to more counter parties at longer maturities and against broader collateral, in addition to series of policy rate cuts. Then, as the erosion of confidence intensified after the failure of Lehman Brothers and market dysfunctions became more pronounced, the central banks began intervening in specific market segments by introducing and expanding asset purchase programs for commercial papers, corporate bonds and government debts. 3 By these augmented liquidity provisions and market function-enhancing interventions, the central banks effectively provided “catastrophe insurance,” or put-like options for a broad range of financial institutions to hedge against some unknown, possibly grave downside risks. In this way, these measures were intended to reduce the fear of “unknown unknowns”. For a more detailed account on the topic, see Nishimura, K. G., “Unconventional Policies of Central Banks: Restoring Market Function and Confidence,” Remarks at the Panel Session “Monetary Policy Boundaries: Alternative Instruments and Policy Coordination” at the Money and Banking Conference sponsored by the Central Bank of Argentina on Sept.1, 2009, available online at http://www.boj.or.jp/en/type/press/koen07/ko0909a.pdf. If a decision maker’s confidence is “contaminated” or eroded in the sense that he/she thinks, though with a small probability (say ε), that he/she is ignorant about the situation he/she faces, his/her rational behavior can be described as “maximin” optimization. In the maximin optimization, he/she is particularly sensitive to the worst-case scenario. See, Nishimura, K. G., and H. Ozaki (2006), “An Axiomatic Approach to εcontamination,” Economic Theory, Vol. 27(2), pp. 333-340. Also, the Fed expanded swap lines with other central banks to enable other central banks to provide further dollar liquidity. A significantly longer duration of liquidity-provision operations helped to substantially reduce financial institutions’ fear over procuring longer-term liquidity. The expansion of counterparties and collateral eligibility secured them new no-risk funding sources, that is, central banks, to partly alleviate a lingering fear of counterparty risks in money markets. I think no additional words are needed about their put-option characteristics of the asset purchase programs. Looking ahead: no free umbrella against plain old rain Clearly, central banks’ provision of catastrophe insurance measures has worked quite well, together with various governmental measures of similar characteristics. 4 Immediate dangers have subsided, though we are still facing a possibly bumpy adjustment process after the collapse of the “credit bubble”. In order to look ahead, the following two points should be kept in mind. First, these catastrophe-insurance measures are in fact “free” insurance. Beneficiaries of these measures do not pay fair, or, in many cases, any premium for these hedges. Rather, central banks and governments implemented these measures against the “unusual and exigent” circumstances of contagious confidence erosion. Thus, the measures were to be temporary. A permanent provision of such free put-like options obviously distorts the market mechanism and prompts undesirable risk taking or “moral hazard.” To put it differently, free shelters should be provided against a hurricane, but there should be no free umbrella against plain old rain. Second, central banks’ ability of providing “catastrophe insurance” is not unlimited and depends crucially on market participants’ confidence in them. Some measures taken by central banks impose financial and possibly reputational risks on themselves. An option provider should make sure that it would not seriously undermine its capital base. That being said, unconventional, catastrophe insurance-like measures should be explicitly temporary and for some measures “self-fading” as market conditions improve. Currently, we see in fact some measures winding down in the US and other places, including Japan, and some other measures, such as the U.S. Treasury’s Guarantee Program for Money Market Funds, to have expired. The wind-down shall be carefully arranged, in some cases step by step, to avoid possible transitional problems as much as possible. Finally, I would like to add that as the immediate threat subsides and the hurricane shelters are removed, nobody assumes that that is the end of public efforts to rebuild the devastated community. This is exactly the same for central banks’ unconventional measures. Although the balance sheets of central banks may be reduced when these unconventional measures are faded out, this is not a sign of a change in the stance of central banks. Rather, this is the sign that central banks can now use conventional means more effectively to pursue current monetary policy. “Put option-like measures” include measures such as capital injections and debt guarantees.
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bank of japan
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Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Kisaragi-kai Meeting, Tokyo, 4 November 2009.
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Masaaki Shirakawa: Recent economic and financial developments and the conduct of monetary policy Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Kisaragi-kai Meeting, Tokyo, 4 November 2009. * * * Introduction I am privileged to have an opportunity to speak before such a large audience. I addressed you the last time in the beginning of November 2008, which was about a month and a half after the failure of Lehman Brothers, and the financial crisis was growing serious. As you remember vividly, the global economy deteriorated rapidly and simultaneously as if falling off a cliff due to the turmoil in the financial markets. The policy responses by the governments and central banks around the world to cope with such a situation were also unprecdentedly bold and massive. Thanks mainly to the effects of those measures, the global financial markets have increasingly been showing signs of improvement since around this spring, and economic activity has also been heading for improvement at home and abroad. At the same time, there are still many challenges to meet. While it is too early to summarize the current crisis, what countries around the world experienced in the past year undoubtedly will become an important event in the history of finance and economics, like the Great Depression in the 1930s. In my speech today, based on the developments in the past year, I will discuss the financial and economic developments at home and abroad, as well as the thinking of the Bank of Japan's conduct of monetary policy. I. Developments in the global economy Background of economic downturn I will begin by discussing the developments in the global economy. There are two important points to note. The first point is how to understand the background of the current global economic downturn. And the second point is how to understand the differences in the pace of recovery between advanced economies and emerging economies, which has recently become marked. I will start with the first point. While the global economy was growing at a high rate of around 5 percent for four consecutive years up to the mid-2000s, in retrospect, the nature of the growth was largely an economic boom against a backdrop of the massive credit bubble mainly in the United States and Europe. In that situation, households and firms substantially increased their debts to make excessive spending. The essence of the current global economic downturn is, put simply, balance-sheet adjustments in the course of unwinding of such excessive financial and economic activity. Inevitably, firms and households have to restrain investment and consumption in order to repay the debts. Such compression of debts, namely, a move referred to as de-leveraging, leads to the contraction of aggregate demand and a decline in asset prices. Financial institutions are also forced to tackle the restoration of balance between overly increased assets, overly shouldered risks, and the capital. In that process, a forward-looking risk-taking activity such as making new lending will simply need to be deferred. While such balance-sheet adjustments are an unavoidable process for the global economy to return to a sustainable growth path, it should be noted that downward pressure on the economy will be imposed as long as the adjustments continue. Another point in understanding the background of the economic downturn is the panicked contraction of financial and economic activity stemming from the liquidity crisis since the autumn of 2008. Triggered by the failure of Lehman Brothers in September 2008, fund providers such as financial institutions and institutional investors became extremely cautious about the creditworthiness of their counterparties. Nagging suspicions spread in many markets, and transactions became extremely inactive. Consequently, the funds necessary for economic activity did not circulate easily, and this, together with heightened anxiety among firms and households, reduced rapidly the global demand. If the balance-sheet adjustment is one cause of protracted "chronic illness," the liquidity crisis since the autumn of 2008 additionally brought a strong "acute pain" to the global economy. The global economy has been picking up recently, and that is because the acute pain has been dissipating for the following three reasons. First, thanks to the ample liquidity provision by central banks around the world, financial markets have gradually restored stability. Policies implemented in the United States and Europe such as government guarantee of financial institutions' debts as well as expansion of deposits to be protected have also staved off further turmoil in the financial markets. Second, in response to the plunge in demand, prompt economic stimulus measures also from the fiscal front have been carried out. A typical example was the policy to enhance purchases of new automobiles implemented in many countries. And third, as a result of the private firms' significant cutbacks in production, inventory adjustments have progressed at a rapid pace. However, the level of economic activity in the advanced economies is substantially low compared with that prior to the failure of Lehman Brothers. In addition, the effects of demand-boosting public measures and inventory restocking will not last forever. For the economic growth to gain momentum, the key is whether a self-sustained recovery of private demand will successfully takeover these effects before they wane. What we should not forget here is the effects of the balance-sheet adjustments that I have mentioned earlier. For the recovery of private demand to gain momentum in the future, balance-sheet adjustments should progress smoothly and the drag on the economy should be removed. However, given the magnitude of the economic bubble in the mid-2000s, the size of the adjustments also appears to be extremely large. According to an estimate by the Global Financial Stability Report of the International Monetary Fund (IMF) released at the end of September, banks' losses stemming from the current crisis have only been provisioned or written-off for 60 percent in the United States and 40 percent in Europe, and thus the adjustment of balance sheets is only half way through. Based on those observations, the pace of growth in the global economy as a whole is likely to remain moderate for some time. Advanced economies and emerging economies The balance-sheet adjustments I have explained are mainly a problem of advanced economies in the United States and Europe. It can be said that emerging and commodityexporting economies basically do not face such a problem this time. As the second point in understanding the global economy, let me touch on the difference in the pace of economic recovery between the advanced economies and the emerging economies and the relationship between the two. The global liquidity crisis since the autumn of 2008 not only affected gravely the advanced economies but also the emerging and commodity-exporting economies. With the turmoil in global financial markets, capital inflows to the emerging economies rapidly contracted, and the world-wide decline in demand hit the emerging economies through the decline in exports. However, with such acute pain receding, the emerging and commodity-exporting economies are recovering faster than envisaged around early spring. The real GDP growth rate for the April-June quarter of 2009 was high in many countries including South Korea, Taiwan, and Brazil. China and India have also been regaining high growths. Going forward, those countries are expected to maintain relatively high growth rates. According to the World Economic Outlook of the IMF released in early October 2009, the year-on-year growth rate of the advanced economies for 2010 remained at 1.3 percent, while that of the emerging economies was at 5.1 percent, and that of Asian emerging economies was particularly high at 7.3 percent. The commodity-exporting countries have also been experiencing a rapid recovery in economic activity and a substantial rise in housing prices, and Australia, followed by Norway, decided last month to raise the policy interest rate. There are several reasons for the economic recovery in the emerging economies. First, the underlying trend in domestic demand in the emerging economies is strong to start with, supported mainly by boosted consumption owing to an improvement in the standard of living as well as need to improve social infrastructure. Those countries, typically China, are likely to potentially have strength to achieve high economic growth. Second, the emerging countries themselves have also implemented aggressive stimulative measures in response to the current crisis. Unlike the advanced countries, the emerging economies were not facing the problem of balance-sheet adjustment and potential demand was strong to start with, thus the multiplier effects of fiscal stimulus might have been significant. Third, the effects of accommodative monetary policy in the advanced economies have spread to the emerging economies. Market participants often use the term "dollar carry trade." There was a period when "the yen carry trade" was talked about, and this time, as many advanced economies are adopting low interest rate policy, funds obtained in the most deep U.S. dollar-fund market are flowing into emerging economies again, and investors are starting to take risk. In addition, since many emerging economies are adopting a fixed foreign exchange policy pegging own currency to the U.S. dollar, that also seems to have brought about monetary easing effects. Those developments have improved significantly the financial environment in the emerging economies mainly through an increase in credit provisioning and a rise in asset prices, thereby underpinning their economic recovery. As such, there are at present two groups of economies in the world, namely the advanced economies that are strongly affected by the balance-sheet adjustments, and the emerging and commodity-exporting economies that are not facing such a problem and are gradually becoming a growth engine for the global economy. As explained earlier, the difference in the pace of recovery between the two groups has enhanced the capital inflows from the advanced economies into the emerging economies, and those capital inflows are likely to contribute to boosting economic activity in the emerging economies for some time. However, if such a situation continues too long, it could lead to overheating of the economy or turmoil in the financial markets, which could lead to an ensuing economic downturn. That is not desirable for the advanced economies either. As economic globalization progresses and economies further strengthen their interconnectedness, there will neither be a de-coupling between the emerging economies and the advanced economies nor a complete coupling of. While it is a common-sense answer, the conclusion lies somewhere in between. What would be important for the global economy is that both the advanced economies and the emerging economies grow together in a well-balanced and sustainable manner without relying too much on each other. II. Developments in Japan's economic activity and prices Economic activity Based on those developments in the global economy, let me turn to Japan's economy. Japan's economy was affected by the effects of global acute pain since the autumn of 2008 and significantly deteriorated. One characteristic of Japan is that the industries related to durable consumer goods and capital goods, such as automobiles, electronic machinery, and general machinery, have a significant share in the economy. Not a few goods of those industries are exported to the advanced economies in the United States and Europe directly or through assembly bases in Asian countries. However, due to the rapid plunge in the global economy since the autumn of 2008 and heightened uncertainty for the future, households and firms around the world rushed to display defensive behavior of curtailing their spending on expensive durable goods consumption as well as machinery and equipment. In addition, the decline in the functioning of global credit markets contracted consumer credits and further reduced the appetite for purchasing mainly durable consumer goods. That is one of the major reasons Japan's exports rapidly declined and production plunged. This suggests that the recovery in Japan's exports should start once the effects of acute pain wane in the United States and Europe. In addition, a faster-than-expected recovery in the emerging economies including China has contributed significantly to the increase in Japan's exports. As a result, exports and production turned upward around this early spring and have been increasing. Against such a backdrop, business sentiment especially at large manufacturing firms has also been improving. As such, although Japan's economy experienced a sharp downturn, it has been improving at a faster pace than other advanced economies. However, we should bear firmly in mind that the level of economic activity is still low, with the GDP remaining at slightly above 90 percent, according to the latest available figure of the April-June quarter, and the level of September industrial production remaining at slightly above 80 percent of that immediately before the failure of Lehman Brothers, respectively. The Bank of Japan uses a somewhat cautious phrase that "Japan's economy has started to pick up" in expressing the current state of Japan's economy, and that reflects also the judgment with respect to the levels I have just mentioned. Let me turn to the outlook for the economy. The Bank issued last week the Outlook for Economic Activity and Prices (the Outlook Report) and presented the outlook for Japan's economy through fiscal 2011. The baseline scenario is that, in the second half of fiscal 2009, the economy is likely to improve gradually on the back of improvements in overseas economies as well as the effects of economic policy measures. Going forward, such tendency is expected to be maintained in fiscal 2010. However, since the pace of recovery in the global economy is likely to remain moderate and also, in Japan, pressure for adjusting employment and wages is likely to remain while the effects of demand-boosting policy measures wane, the pace of improvement in Japan's economy is likely to be moderate until around the middle of fiscal 2010. Thereafter, as balance-sheet adjustments in the United States and Europe make fair progress, the improvements in the corporate sector originating from exports are likely to spill over to the household sector. Therefore, in fiscal 2011, Japan's economic growth rate is likely to clearly increase. However, the outlook is accompanied by various uncertainties. What worries me the most is the possible consequences of balance-sheet adjustments in the United States and Europe, as well as developments in the emerging and commodity-exporting economies. Besides, there are downside risks to the economy such as developments in firms' medium- to longterm expectations of future economic growth. However, given that the emerging and commodity-exporting economies are likely to continue growing at high rates, risks have been becoming balanced, compared with a situation in early spring when risks were generally tilted downside. Prices Based on the developments in the economy I have explained, I will now turn to the price developments in Japan. Since 2008, the consumer price index (CPI) in Japan has been subject to a large swing due mainly to the changes in the prices of petroleum products. The year-on-year growth rate of the CPI (excluding fresh food) was on a declining trend following its peak at 2.4 percent in the summer of 2008 and became negative after March 2009. The pace of decline accelerated thereafter due mainly to the base effect from last year's high petroleum product prices, and the CPI (excluding fresh food) marked a record decline of 2.4 percent in August, year-on-year, and declined by 2.3 percent in September. The Bank views the outlook for prices as follows. The pace of year-on-year rate of decline in the CPI (excluding fresh food) is expected to slow down significantly in the second half of fiscal 2009. That is because the base effect from last year's high petroleum product prices will dissipate. Thereafter, the CPI (excluding fresh food) is expected to be basically subject to the development in the aggregate supply and demand balance. From fiscal 2010 onward, the rate of decline in the CPI (excluding fresh food) is likely to continue to moderate, as the economy picks up as well as the aggregate supply and demand balance improves gradually. However, downward pressure on prices is likely to remain for a relatively long period, given that the negative output gap, which underlies this projection, is larger than ever and that the pace of economic recovery is likely to be moderate. Since the current plunge in demand was as sharp as no country experienced for a long period, it is commonly considered also in the United States and Europe that it will take a considerable period for inflation rates to recover to the past levels. In those circumstances, what is important is whether, as a future baseline scenario, Japan's economy returning to a sustainable growth path with price stability is in sight. It is an issue for those who worry about the effects of price decline, whether the continued decline in prices, albeit modestly, will postpone spending, leading to further acceleration in price declines. What might serve as a reference here is Japan's experience in the first half of the 2000s. While there were many arguments about deflation at that time, eventually Japan's economy started to recover amid the continued modest decline in prices. The year-on-year growth of the CPI had been slightly negative, at around just under minus 3 percent on a cumulative basis, for seven years from fiscal 1998 to 2004. Meanwhile, despite the price decline, the economy continued to recover from fiscal 2002 to 2007. While that has been a puzzle to one who worries about deflation, such a situation has been drawing interest from the overseas policy authorities and economists. In this regard, a difference from the global economy in the 1930s, when deflation was a grave problem, might give us a clue. Unlike Japan in the early 2000s, prices plunged by more than 20 percent on a cumulative basis, or more than 30 percent in some countries, in the global economy in the 1930s. Moreover, in the 1930s, the authorities could not come up with effective policy measures in response to successive bank failures and the financial system became extremely unstable, leading to a situation in which firms facing funding difficulties rushed to sell off their own products. In contrast, although Japan did face difficult problems, it succeeded in managing to avoid financial system instability due to such measures as ample liquidity provision by the Bank of Japan. Looking at the current phase while bearing those episodes in mind, Japan's financial system has been generally stable, and, in terms of cumulative decline in prices, the level of the CPI as of September returned to the level of August 2007, just before the surge in petroleum products started. Firms' and households' medium- to long-term inflation expectations are considered to be stable so far, according to various surveys and developments in long-term interest rates. Based on those observations, the Bank judges that, at present, it is unlikely that the decline in prices will induce downward pressure on economic activity. Of course, like the outlook for economic activity, the outlook for prices is also accompanied by uncertainty. As explained earlier, year-on-year changes in prices in Japan rose to around 2.5 percent in the summer of 2008 due mainly to the surge in prices of petroleum products, and this year, because of the base effect, prices have been declining by more than 2 percent, year-on-year. Several years ago, there were not many people who could forecast that such changes in prices would take place, including those in the Bank and international institutions, as well as economists. As such, it is the reality that the accuracy in predicting price changes during a phase of a large economic swing is not high. Therefore, we believe that it is important to maintain a stance of examining all available data, without having any prejudgment about the outlook. The financial environment So far I have explained the developments in economic activity and prices. I will now turn to Japan's financial environment. The turmoil in global financial markets since autumn 2008 spread over to Japan's financial markets, especially CP and corporate bond markets where large firms raise funds. The issuance rates of CP and corporate bond soared, and the corporate bond market was in an abnormal situation that issuance virtually stopped. Together with a deterioration in economic activity, funding conditions of large firms became increasingly tight. The worsening financial environment for large firms affected funding conditions at small firms mainly through two channels. First, since large firms that faced malfunctioning of CP and corporate bond markets had shifted their funding sources to borrowing from banks, banks responded by using much of their remaining lending capacity. And second, the worsening of funding conditions at large firms had contracted business-to-business credit for trading partners and affiliated firms. As a result, in the March 2009 Tankan (Short-Term Economic Survey of Enterprises in Japan), the diffusion index of funding conditions plunged to the lowest level in about 10 years since 1998, regardless of firm size. Subsequently, thanks to the regained stability in global financial markets and the effects of various policy measures in Japan, Japan's financial environment has been showing signs of improvement. In particular, the issuing conditions of CP and corporate bonds have improved markedly. In the CP market, issuance spreads for even low-rated firms have declined to a level below those before the failure of Lehman Brothers and the Bank judges that the market has already come back to a normal state. In addition, the corporate bond market has also restored favorable issuing conditions as a whole, as seen in the fact that credit spreads have declined and the total value of issuance in the first half of fiscal 2009 marked a record high. Nevertheless, we should not forget that there is still lingering severity in Japan's financial environment. In particular, the improvement in funding conditions at small firms has been limited, compared with that of large firms. That would basically be attributable to the severe profit environment for small firms, as shown in the moderate pace of improvement in their business sentiment, albeit underpinned to some extent by the emergency guarantee program. The Bank will continue to examine corporate financing as a whole including that of small firms, through various surveys such as the Tankan as well as interviews through the Bank's branch network. III. Conduct of monetary policy I have explained the developments in the economies at home and abroad as well as the developments in prices. Based on those developments, I will finally explain the Bank's thinking behind the conduct of monetary policy. The Bank reduced the policy rate to 0.3 percent in October 2008 and to 0.1 percent in December 2008 and has been maintaining the level unchanged since then. To address the rapid contraction of financial markets triggered by the failure of Lehman Brothers, the Bank implemented various temporary measures, including extraordinary ones for a central bank such as outright purchases of CP and corporate bonds. At the Monetary Policy Meeting (MPM) held on October 30, the Bank made a decision on the policy rate and those various measures. The policy rate was decided to be maintained at the extremely low level of 0.1 percent. As mentioned earlier, the recovery in Japan's economy has just started, and it is likely to take some time for the economy to fully return to a growth path. The Bank will maintain the extremely accommodative financial environment and thereby provide steady support for Japan's economy to return to a sustainable growth path with price stability. Next I will explain the management of various temporary measures. At the MPM, we decided on specific handling of measures from a perspective of what might be the most effective method that conforms to the degree of improvement in the acute pain, and will ensure financial market stability and thereby facilitate corporate financing. It was decided that special funds-supplying operations to facilitate corporate financing will remain in effect until the end of March 2010 and will expire. This is a measure to supply funds at a fixed interest rate of 0.1 percent with a term of three months, for an unlimited amount against the value of private corporate debt pledged as collateral. While the operations contributed to stabilizing financial markets, the similar effects could be mostly achieved by the existing money market operations since the stability of financial markets has been restored. Nevertheless, we decided that the operations would remain in effect until March 2010 to further ensure financial market stability toward the end of the fiscal year. From April 2010 onward, the Bank will be prepared to provide ample liquidity by further utilizing the existing money market operation measures, which accept a wider range of collateral and have more flexibility in setting terms. We have clarified our intention after April at this point since we thought giving market participants a certain preparation period before the transition to a new system would facilitate smooth transition without any confusion. The Bank's outright purchases of CP and corporate bonds will expire at the end of 2009 as scheduled. As issuing conditions in the CP and corporate bond markets improve, actual bids in the auction of outright purchase of CP has been zero for four consecutive auctions since mid-September. The bids for the outright purchase of corporate bonds have also been declining. As seen in those improvements, the Bank considers that the purpose of the purchases to restore market functioning in the impaired CP and corporate bond markets has fully been achieved. Meanwhile, a distortion of market functioning has recently been becoming prominent, as witnessed by the issuance rates of CP becoming lower than yields on government bills and, as a result, investors are increasingly becoming fewer. The Bank thus made the decision that the termination of the purchases would be useful in achieving the smooth flow of funds. In addition, the Bank decided that the complementary deposit facility introduced in the autumn of 2008, to which interest is paid on part of financial institutions' deposits at the Bank, would remain in effect for the time being. While I will not go into technical details, the facility is a mechanism for avoiding substantial changes in market interest rates under ample liquidity provision by the Bank and thereby ensure stable interest rate formation. Upon this extension, an important infrastructure for the smooth conduct of money market operations while providing ample funds will continue to be secured. As central banks around the world have been striving to ensure the stability of financial markets and financial systems through ample liquidity provision, demand for central bank funds is expected to recede as each country's financial environment further stabilizes with the dissipation of the acute pain. As a result, funds supply by central banks might decline. Looking at the size of major central banks' balance sheets and reserves since the autumn of 2008, they have been changing, reflecting the extent of impairment of financial market and financial system of each individual country. For example, since Japan's financial markets and financial system have been stable, compared with those in the United States and Europe, the balance sheet of the Bank has not been expanding that much. In contrast, in the United States where the current financial crisis was originated, the amount of excess reserves at the Federal Reserve rose to above 6 percent of nominal GDP, which is a level slightly above the peak of the Bank of Japan's excess reserves of 5.8 percent at the time of quantitative easing policy. When balance-sheet adjustments have been progressing, massive liquidity provision by central banks has not been affecting the rate of inflation, but has contributed substantially to restoring stability in the financial system. Going forward, the Federal Reserve's balance sheet is likely to shrink as the financial environment further improves, and even in that case, it is an evidence that financial markets have further stabilized, rather than signaling a change in central banks' accommodative monetary policy stance. I reiterate that, in the conduct of monetary policy, the Bank will provide steady support for Japan's economy to return to a sustainable growth path with price stability, by maintaining the extremely accommodative financial environment. That means that the Bank will underpin Japan's economy so that it will be able to exert its potential strength. A more critical challenge for Japan is to raise "the potential strength," or put it differently, the long-term growth path itself. On this point, I will add that the key will be to improve profitability in investment and productivity of the economy as a whole through active efforts of private firms. Closing remarks In closing, I will share with you what I have in my mind based on the experience of the past year. Those thoughts all relate to the role of a central bank. First, the importance of decisively taking action upon accurately recognizing the role expected of a central bank. In any country, a central bank is an organization to carry out policies and business operations by highly valuing a self-sustained market mechanism. Nevertheless, when being confronted with a crisis that the financial system might collapse, a central bank will do its utmost to prevent the collapse of the financial system by using all central bank functions, including outright purchases of CP and corporate bonds, or sometimes creating new measures. While those actions will be carried out to protect the markets, it will indeed be a significant intervention against the market mechanism. Therefore, it sometimes becomes quite difficult for a central bank to draw the clear line between what it "should do" and "should not do." A central bank will be required to implement decisively even extraordinary measures if necessary, within a range allowed by law, to achieve the objective of a central bank to ensure economic and financial stability. At the same time, however, because a central bank is the sole organization that has a privilege of issuing interest-free debt, there will be considerable adverse effects of continuing the extraordinary measures to intervene in the markets after they have become unnecessary. In that regard, I am of the view that a central bank's proper actions are critical both during and after a crisis, and keeping this in mind, I believe that the Bank will fulfill the missions of a central bank. And the second point concerns the prevention of a crisis. While the current crisis is not over yet, various efforts have been made to prevent the recurrence of a crisis, based on the lessons learned. For example, as a framework for preempting crisis, discussions are underway on the capital adequacy ratio and review of financial regulations and supervisory system. Moreover, a perspective of macroprudence, through which the existence of risks are checked and assessed upon reviewing the financial system as a whole, has been widely recognized. However, the cause of a bubble will eventually boil down to the human nature such as bullish expectations in a benign financial and economic environment or a decline in self-discipline against risks. That itself raises a difficult issue of how a central bank should deal with such an elusive problem. I have discussed earlier the dollar carry trade, and the fact that people are able to easily take risk without geographical and time constraints, thanks to the recent financial and economic globalization and progress in information technology, has made the responses of a central bank all the more difficult. What is obvious is that a crisis will always come in a new form. By exchanging views with the policy authorities at home and abroad, market participants, and academics, and continuing to learn humbly, the Bank of Japan will meet such new challenges. Thank you.
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Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Paris EUROPLACE Financial Forum, Tokyo, 16 November 2009.
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Masaaki Shirakawa: Balance-sheet adjustments and the global economy Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Paris EUROPLACE Financial Forum, Tokyo, 16 November 2009. * * * Introduction Thank you for having me today at the International Financial Forum organized by Paris EUROPLACE. Counting the Banque de France, financial institutions, clearing systems, law firms, and accounting offices among its members, Paris EUROPLACE is an organization with a wide range of members with an interest in French financial markets. Communication among market participants is important for the development of markets, but it is particularly crucial during a period of financial crisis. I have learned that Paris EUROPLACE plays an important role in providing the opportunities for such communication, and I salute the members of Paris EUROPLACE for their contributions. At this forum today, reflecting the current financial crisis, various workshops will be held to address issues concerning financial markets and the financial system, and the workshops will no doubt give rise to active discussions. The topic I would like to talk about today is balance-sheet adjustments. As the governor of the central bank of a country that has experienced the hardship brought by balance-sheet adjustments before any other advanced economy, I believe that balance-sheet adjustments are a key factor in shaping the prospects for the global economy following the economic crisis. I. Global economic developments and balance-sheet adjustments I will start by discussing recent developments in the global economy. Following the failure of Lehman Brothers in the autumn of 2008, global financial market conditions deteriorated significantly and economies around the world contracted simultaneously and sharply. Recently, however, global financial markets have increasingly been showing signs of improvement, and the global economy has started to pick up. On the whole, Japan's economy has followed a similar trend as other advanced economies, although both the economic contraction and the subsequent recovery were greater in Japan. The reason is that industries that were the most severely affected by the global economic downturn, such as automobiles, electrical machinery, and general machinery, carry a particularly large weight in Japan. The current pick-up in the global economy is supported by the following three factors. First, dissipation of the panic, namely the liquidity crisis. Second, progress in inventory adjustments. And third, the implementation of massive economic stimulus measures around the world. However, the fundamental problem that caused the current economic crisis, that is, the need for balance-sheet adjustments due to the bursting of the credit bubble in the United States and Europe, remains unresolved. This means that households and firms will have to restrain consumption and investment in order to reduce the debts accumulated when asset prices were rising. While such debt reduction, in other words, deleveraging, is a rational response from the perspective of individual households and firms, if they restrain spending simultaneously in large numbers, this could cause a decline in aggregate demand and a fall in income and profits, which provide the necessary resources for deleveraging. Financial institutions, too, will inevitably have to reduce assets and risks, which had grown excessively relative to their capital bases. While balance-sheet adjustments are indispensable for the economy to return to a sustainable growth path, they will continue to exert chronic downward pressure on the economy during the adjustment process, as Japan's experience shows. Meanwhile, emerging and commodity-exporting economies essentially face few balance-sheet problems of their own and have been recovering at a faster rate than anticipated in early spring. Given these considerations, a key issue in determining the outlook for the global economy is how to assess the pressures from these balance-sheet adjustments in U.S. and European economies. Comparing Japan's experience of balance-sheet adjustments in the 1990s and the current situation in the United States may provide some important pointers in this context. II. Balance-sheet adjustments and policy responses The size of balance-sheet adjustments Let me begin by comparing the size of balance-sheet adjustments necessary in Japan and the United States. Taking as an example real estate prices in real terms – using the consumer price index as deflator – the pace of decline in both residential and commercial real estate prices from their peak levels has been more or less the same in the United States and Japan, although thus far it seems to have been slightly faster in the United States. Next, how do the two square up in a more direct comparison of the degree of excessive leverage? One way to gauge excessive leverage is to look at the upward divergence of the debt-toGDP ratio for the non-financial private sector from the trend of the past 20 year. Based on this somewhat mechanical approach, we find that the level of excessive leverage is also about the same for Japan and the United States. Sectors that require balance-sheet adjustments Another difference between Japan and the United States is the sectors requiring balancesheet adjustments. In the case of Japan, it was the corporate sector that mainly faced excessive debt within the non-financial private sector. The excess of investment over savings reached more than 10 percent of GDP in 1990. Amid the rise in asset prices, firms had made aggressive real-estate investments and, at the same time, increased business fixed investment by borrowing from banks using real estate that had gone up in value as collateral. After the bubble burst, economic activity deteriorated together with the fall in asset prices, and the corporate sector was confronted with excesses in debt, production capacity, and employment. In contrast, in the current situation in the United States, it is the household sector that needs to make balance-sheet adjustments. As seen in the subprime mortgage problem, against the background of rising home prices, households' borrowing against homes as collateral increased substantially, which in turn led to excessive consumption. Policy responses amid balance-sheet adjustments Next, I would like to look at differences in the policy responses in Japan and the United States. The first aspect in this regard is the timing and scale of policy responses. Starting with monetary policy, both the Bank of Japan and the Federal Reserve undertook the first policy rate reduction about one year after real estate prices in major cities had reached their peak. Therefore, the time it took for the Bank of Japan and the Federal Reserve to start lowering interest rates was about the same. On the other hand, the pace of policy interest rate reductions was faster in the United States than in Japan, reflecting the difference in the sequence in which impaired asset problems arose, as described later. In Japan, the policy rate reached 0.5 percent after four years from the start of rate reductions, while in the United States, it was after only 15 months. With regard to the scale of injections of public capital into the financial sector, which are a key to the restoration of the functioning of financial intermediation, the size of public capital injections relative to GDP was approximately 2.5 percent in Japan, while it was 1.5 percent in the United States. The relative size of injections was slightly larger in Japan, but injections were undertaken considerably earlier in the United States. In the United States, because the bursting of the bubble started with a fall in market prices of securitized products, financial institutions' capital shortages were revealed at an early stage by market forces. In contrast, in the case of Japan, it took time before financial institutions' capital shortages were recognized and public capital was injected. The reason is that financial institutions' impaired assets consisted mainly of loans and it was more difficult to gauge the decline in their value. It should, however, be noted that currently in the United States, commercial real estate prices continue to fall and the quality of consumer loans continues to deteriorate, and therefore the sequence in which the problems related to impaired assets arise is different in the United States from that in Japan. Meanwhile, in terms of financial market stability, which is key to avoiding a sharp economic contraction, the degree of instability seems to have been relatively smaller in Japan reflecting partly the Bank of Japan's active stance as the lender of last resort. The balance-sheet adjustment process and the effectiveness of monetary policy The second aspect with regard to the policy response concerns the effectiveness of monetary policy. As Japan's experience shows, the effectiveness of accommodative monetary policy through policy rate reductions declines substantially in an economy that is undergoing balance-sheet adjustments. This, of course, does not mean that monetary easing is ineffective. Monetary easing encourages spending and risk-taking activity by entities that are not suffering from excessive debt and supports aggregate spending and income. Monetary easing also enhances debt reduction through a decline in interest payments and accelerates balance-sheet repairs by supporting asset prices. One of the distinct differences between Japan and the United States in terms of the conduct of monetary policy amid balance-sheet adjustments concerns the income transfer effects between economic entities. Needless to say, in the economy as a whole, for economic entities with excess debt there will correspondingly be entities with excess savings. In Japan, as a result of the reduction in the policy rate, there was a large income transfer from the household sector, which held large amounts of assets, to the heavily indebted corporate sector. However, in terms of income distribution, I believe that in the final analysis, the policy rate reductions supported household sector income: although they lowered households' interest income, thereby restraining consumption to some extent, the policy rate reductions facilitated the adjustment process in the corporate sector and supported economic activity overall, thereby propping up household sector income from employment and hence the economy. Meanwhile, since the United States, unlike Japan, is a net debtor country, the reduction in policy interest rates will reduce interest payments to creditors overseas, resulting in an income transfer from overseas sectors to the United States. In other words, in terms of balance-sheet adjustments, the United States has the advantage that policy interest rate reductions bring about income transfers that are favorable to the country. However, there are also risks involved in continued low interest rates. If the continuation of low interest rates leads to a substantial rise in long-term interest rates by raising inflation expectations or by generating expectations for a weak dollar, this may give rise to another problem, namely that the fiscal burden increases and in turn the need for adjustments in the government's balance-sheet arises. Effects resulting from different sectors making balance-sheet adjustments The difference between the United States and Japan in terms of what sectors have to or had to make balance-sheet adjustments can result in considerable differences not only in income transfer effects, but also in the adjustment process. In the case of Japan, since it was mainly the corporate sector that had to make balance-sheet adjustments, progress in the adjustment process for the economy overall was achieved through an increase in exports owing to high global economic growth. However, at present, it is difficult for the United States to expect similar help from a substantial rise in its exports, because other advanced economies are also, to a greater or lesser extent, undergoing balance-sheet adjustments. An additional problem is that employees' income has declined more substantially than in previous recessions in the United States. While this may help the recovery in corporate profits, it at the same time entails the risk of a delay in balance-sheet adjustments by households. Having said that, I must hastily add that there are elements in the structure of the U.S. economy that will encourage rapid progress in balance-sheet adjustments. The size of necessary balance-sheet adjustments depends on the size of the excess in supply capacity in the overall economy relative to the long-term equilibrium growth rate – that is, the potential growth rate. If expectations for economic growth are high, pressures for balance-sheet adjustments will be small. In this context, the United States has the significant advantage of having a flexible economic structure. If labor and capital shift swiftly from low-productivity sectors to high-productivity sectors, this should sustain high productivity growth in the economy overall. In contrast, reflecting population aging and a falling birth rate, the growth rate of Japan's working-age population first declined and then turned negative during the 1990s. Moreover, labor and capital mobility was relatively low, which was partly responsible for the gradual decline in productivity growth in the economy overall. As a result, Japan's potential growth rate after the bubble burst declined, which protracted the duration of balance sheet adjustments. III. Balance-sheet adjustments and the global economy Lastly, I will broaden my perspective and touch upon the relationship between balance-sheet adjustments and the global economy. What is important in this context is the relationship between developments in emerging and advanced economies. Currently, large-scale economic stimulus measures are being implemented around the world. Although emerging economies did not face pressure for balance-sheet adjustments, given the decrease in global demand they nevertheless implemented large-scale economic stimulus measures. In addition, monetary easing in advanced economies has stimulated capital inflows to emerging economies, boosting economic activity there. On top of that, the effects of monetary easing have been magnified by foreign exchange interventions by emerging economies to contain the appreciation of their currencies. In these circumstances, economic activity in emerging economies has been recovering at a faster rate than anticipated in early spring, contributing to the recovery of the global economy overall. However, we also need to be aware of the risk that if the difference in the pace of recovery in emerging and advanced economies does not diminish, and if capital inflows from advanced economies continue for a protracted period, emerging economies might overheat and experience financial turmoil, triggering a recession. Although this may be stating the obvious, given the growing interconnectedness between economies around the world, what is important for the global economy is that advanced and emerging economies grow in a sustained and well-balanced manner. Therefore, it is necessary to pay attention to the relationship between developments in advanced and emerging economies and especially to capital flows from advanced to emerging economies. Closing remarks In my speech today, using Japan's experience in the 1990s for comparison, I highlighted a number of issues concerning balance-sheet adjustments that will play an important role in shaping the outlook for the global economy. As a policymaker, I believe it is important to be aware of the issues I discussed today and, keeping duly in mind that the past is not necessarily a good guide to the future, to continue to carefully assess economic developments without any prejudgment. Thank you.
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Lecture by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Faculty of Law, University of Tokyo, Tokyo, 21 October 2009.
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Masaaki Shirakawa: The Central Bank from the viewpoint of "law and economics" Lecture by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Faculty of Law, University of Tokyo, Tokyo, 21 October 2009. * I. * * Introduction I am happy to be speaking to you from this podium at the law faculty today. I feel that I have made something of a long detour in life before reaching this classroom. I entered the University of Tokyo in 1968 to advance to the faculty of law, but my interests led me instead to the faculty of economics, so I never stepped inside a law faculty classroom during my undergraduate days. So I am now filled with an inexpressible feeling as I stand here finally after 40 years. Nevertheless, I have felt a sense of familiarity with the world of law for a long time. While you might imagine that work at the Bank of Japan frequently employs knowledge of economics, there are also many tasks that require knowledge of law or the so-called legal mind. During some 34 years of service at the Bank before I assumed my current position, I carried out a variety of responsibilities related to monetary policy, research and studies, financial markets and the payment and settlement system, and the disposal of failed financial institutions. In those days, I keenly felt the importance of having knowledge not only of economics but also of law. Today, therefore, I will talk about the role of a central bank from the viewpoint of "law and economics." First, I will briefly explain the mission and role of the Bank. The Bank of Japan is the nation's only central bank. If I were to express the mission of a central bank in one sentence, it would be "to issue money, or currency, and to ensure that people can use it with confidence." The money most close to you is likely to be banknotes, namely "Bank of Japan notes," and the Bank of Japan is the organization that issues those banknotes (Chart 1). The face values of "Bank of Japan notes" significantly exceed their production costs.1 Nevertheless, nobody worries about whether a 10,000 yen banknote in your wallet will turn into a mere sheet of paper, or that it might not be accepted by the stores. While banknotes are the most typical form of money, what is greater in terms of value is what you deposit at banks, namely, bank deposits (Chart 1). Deposits are based on a private law contract between depositors and banks. You need not worry that those deposits will not return to you as stipulated in the contract or that they will become valueless. "Money" such as cash and deposits is vital for economic activity. Economic activity cannot proceed stably if people worry that currency might not be accepted or become valueless. To ensure that people can use money with confidence, thereby contributing to economic growth; this is the most fundamental mission of a central bank. II. Experience of the global financial crisis Let me explain the work of a central bank more specifically. Here, I will take up the global financial and economic crisis after the failure of Lehman Brothers in September of last year. See Annual Review 2009 (for fiscal 2008) (available on the web site of the Bank of Japan). The reports, speeches and other materials published by the Bank and hereafter referred to are available on its web site (unless expressly stated to be available on the web site of the Institute for Monetary and Economic Studies of the Bank). From the autumn of last year2, global economic activity plummeted and global trade also contracted rapidly (Chart 2). This situation was the first such experience in 70 years. Quite recently, economic activity has been picking up, although the current level of economic activity is still significantly lower than that of last year. What circumstances were behind this? Up to the mid-2000s, the global economy had been enjoying a long period of benign economic conditions of high growth, low inflation rates, and low interest rates. As a result, people became bullish about the future, and willingly took risks and invested in various sectors such as real estate. This was the so-called bubble. What is happening now is the unwinding of the "excesses," namely, the bursting process of the "bubble." In the United States, housing prices peaked in the second quarter of 2006 after rising steadily for a long period. Then, people who took out mortgages on the prospects for rising house prices became unable to repay their mortgages. Banks did not hold all the mortgages on their balance sheets, but aggregated them in pools so that new securities could be issued by the pools and sold to other financial institutions and investors. These were called "securitized products" (Chart 3). Because of issuance in several tranches according to the order of interest received from a pool of loans or principal repayments, the senior tranche in the securitized products obtained high ratings. However, as house prices plunged and a larger-than-expected number of mortgages turned delinquent, the prices of securitized products including highly rated ones dropped significantly. Thus, financial institutions holding a large amount of the securitized products also incurred huge losses. In these circumstances, leading financial institutions faced a management crisis and Lehman Brothers filed for insolvency in September 2008. Financial institutions mutually make various transactions, and thus many debts and credits are mingled together. Since financial institutions other than Lehman Brothers incurred losses, albeit to different degrees, they began to worry that their trading counterparts might go bankrupt. In such a situation, financial institutions became reluctant to lend to or borrow money from each other in the market. In addition, even when financial institutions lent to their counterparties, they charged high interest rates on the loans (Chart 4). As a result, financial institutions started to worry that they might not be able to borrow required funds in the market, and became cautious about lending to firms and individuals. For example, commercial paper (CP) that firms issue to raise short-term funds faced a decline in the amount issued and a rise in the issue rate since financial institutions stopped buying the CP (Chart 5). Among the buyers of the CP were mutual funds such as money market funds (MMFs) that invested in various products including securitized products. In preparation for investors' withdrawal, the mutual funds held back investments in the CP. That was also a blow to the CP market. The securitized products, which were the epicenter of the current crisis, had no buyer in the sagging market and, as a result of the limited room for risk taking on the part of financial institutions, the products faced a significant decline in trading volume and extremely high issue rates (Chart 6). To put this phenomenon more concisely, it was a "collapse of confidence." Financial transactions are based on confidence. Even a simple sales contract entails various kinds of risks. First, there is credit risk as to whether a trading counterparty has sound financial conditions and is immune from default. Second, there is liquidity risk as to whether a buyer can secure funds necessary for payment. Third, there is payment and settlement risk as to whether products or payments are delivered as stipulated in the contract, namely, whether payment and settlement are smoothly carried out without the risk of not receiving money or As for the cause of the current global financial crisis, see "Way Out of Economic and Financial Crisis: Lessons and Policy Actions," a speech given by Masaaki Shirakawa, Governor of the Bank of Japan, at the Japan Society in New York on Thursday, April 23, 2009. products. If these risks are deemed significant then one cannot make a contract, out of fear. In particular, since financial transactions are large in amount and complex in contents, financial transactions will not be carried out in the usual manner if financial institutions are extremely sensitive to the risks. If financial transactions cease, funds necessary for economic activity will not be distributed and economic activity will stagnate further. As such, in the current global financial and economic crisis, confidence, which is the most important element in finance, collapsed during the process of the unwinding of the "excesses." Consequently, the flow of funds stopped and the economy deteriorated further, aggravating the crisis. III. Measures taken by the Bank of Japan Since financial institutions are globally linked through various transactions and economies are also globalized through trade and investments, the crisis that started in the United States spread quickly around the world. Although Japanese financial institutions did not hold many securitized products, Japan's economy was affected significantly because of the global economic and financial mutual relationship. In facing this global crisis, the Bank has taken a number of measures. I will now explain the four particularly important ones.3 Reductions in the policy interest rate First, there was a reduction in the interbank interest rate to a low level of 0.1 percent. With a view to achieving stable economic activity and prices from a longer-term perspective, a central bank raises or reduces the short-term interest rate based on the future assessment. This is what is referred to as monetary policy in the orthodox definition of textbooks.4 This time, in response to the global economic slowdown, central banks around the world reduced short-term interest rates to a level expressed as the "zero interest rate" (Chart 7). Provision of ample liquidity Second, the Bank provided ample liquidity in order to ensure stability in financial markets and financial systems. As mentioned earlier, when mutual confidence in financial institutions declines and concern arises that funding in financial markets might be impaired, this constrains financial institutions from lending to firms and individuals. In such a situation, the Bank provided the market with ample liquidity to preempt such concern. It is no surprise that central banks provide funds in their home currency in a crisis. This time, however, central banks of not only the United States but also other countries coordinated to arrange for a framework of U.S. dollar-funds provision. Specifically, the Bank of Japan and other European central banks made swap arrangements, received the supply of dollars from the central bank of the United States, the Federal Reserve, and supplied them to financial institutions in their own countries (Chart 8). This made dollar funding of financial institutions in each country easier. For the policy measures adopted by the Bank during the current financial crisis, see "The Bank of Japan's Policy Measures in the Current Financial Crisis", and regarding the policy measures adopted by the major central banks, see "Konji Kin'yu Kiki ni okeru Shuyo Chuo Ginko no Seisaku Un'ei ni tsuite (Major Central Banks' Policy Operations in the Current Financial Crisis)", published by the Monetary Affairs Department of the Bank (July 2009, available only in Japanese). There are, however, a variety of issues regarding how to define monetary policy. In this regard, see "Opening Speech by Masaaki Shirakawa, Governor of the Bank of Japan, at 2008 International Conference 'Frontiers in Monetary Theory and Policy' hosted by the Institute for Monetary and Economic Studies, Bank of Japan, in Tokyo on May 28, 2008". Both the Bank of Japan and all other central banks require collateral when providing liquidity. In the case of the Bank, Japanese government bonds, bills, and bonds normally are accepted as eligible collateral (Chart 9). In the current phase, the Bank made it possible to provide the yen or the dollars against foreign government bonds as eligible collateral. This framework is called cross-border collateral arrangement. Other central banks have introduced or have been trying to introduce a similar framework. Since internationally active financial institutions diversify assets located around the world denominated in various currencies, the adoption of such a framework by central banks enables the financial institutions to borrow funds from central banks by using effectively assets located in various countries. Support to malfunctioning capital markets While the second measure I have just explained is a measure to indirectly support financial institutions' lending to firms by providing financial institutions with ample liquidity, the Bank has also implemented more direct measures, given that this time firms were unable to raise funds in the capital market. One of these measures was the outright purchases of CP. The Bank has been providing financial institutions with loans against CP as collateral, or purchasing CP from financial institutions on the condition of selling back in the future. In these cases, the risk of incurring losses when a firm issuing the CP goes bankrupt, namely, credit risk, is primarily assumed by financial institutions. If the Bank purchases CP without the condition of selling back, however, the Bank bears the credit risk (Chart 10). It is a principle that under normal circumstances a central bank provides liquidity to the financial market as a whole, and private financial institutions and investors that know a borrowers' conditions well will carry out individual fund allocation. In this regard, it is an exceptional step, as in the current crisis, for central banks to themselves directly bear credit risk for individual private firms and provide liquidity. When the functioning of financial markets declined markedly, leading to tightening in most areas of corporate finance, the Bank decided to implement outright purchases of CP and corporate bonds as temporary measures. The Bank judged that these measures would be necessary to fulfill the mission of the central bank, that is, to distribute funds necessary for economic activity to every corner of the economy by maintaining stability in the economy, prices, and the financial system. Risk reduction measures in the payment and settlement system As the fourth measure, I will explain that, in coping with a financial crisis, it is important to always prepare for a crisis with down-to-earth efforts to establish systems. As an example, I will discuss the foreign exchange payment system such as yen-dollar transactions. From the autumn of last year, it became extremely difficult to raise funds in the U.S. dollar funds market due to the collapse of confidence. The difficulty in dollar funding was a particularly grave problem for foreign financial institutions that did not have dollar deposits in Japan, in other words, that lacked a relatively stable funding source. What was used in these circumstances was a "swap transaction," which exchanges the yen and the euro for the dollar for a certain period of time (Chart 11). Since this was dollar funding using the yen and the euro as collateral, or vice versa, it was relatively safer than uncollateralized funds transactions. The swap market accounts for almost half of the entire foreign exchange market, and is a large market with a trading volume of 1.7 trillion U.S. dollars per day in the world. There is a time-zone difference between the delivery of the yen, which is made in Japan, and the delivery of the dollars, which is made in the United States. Suppose that a financial institution delivers the yen first to a counterpart financial institution and receives the dollars later; this financial institution faces the risk of not receiving dollars in the event the counterpart financial institution goes bankrupt before the New York market opens. While such time-lag risk is not recognized in normal times, it becomes critical in a crisis. To prepare for such a situation, central banks had long been encouraging private financial institutions around the world to establish a simultaneous settlement method among major currencies including the yen and the dollar; it is called payment versus payment (PVP). As a result, the Continuous Linked Settlement (CLS) system was established in 2002, with financial contributions from private financial institutions around the world (Chart 12). If the current global financial crisis had taken place in the absence of such a system as CLS, foreign currency funding by financial institutions might have faced more difficulties and the crisis might have worsened further. IV. The role of the Central Bank I have so far been explaining the role of a central bank by using the example of the current global financial and economic crisis and central banks' responses. Here, I will explain in a more general way the central bank's role to "ensure that people can use money with confidence," which I mentioned at the outset.5 As a lecture in the faculty of law should do, I will start with an article of law. In the Bank of Japan Act, there is an article that stipulates, "The banknotes issued by the Bank of Japan (hereinafter referred to as “Bank of Japan notes”) as prescribed in the preceding paragraph shall be legal tender and hence shall be used for payment without limits" (Article 46, Section 2) (Chart 13). Because of this stipulation, transfer of a banknote will be "the performance actually consistent with the purpose of the obligation" that you have learned in the class on civil law. If a borrower tenders the Bank's banknote as a tender of performance, the creditor must accept it. In this regard, this article is quite important. Even with such an article, Bank of Japan notes might not be used in the actual transactions. Under the principle of the freedom of contract, an individual is free to either make or forgo a contract. If a seller does not want to sell the product in exchange for the Bank of Japan note, the sales contract will not go through to start with, and thus the Bank of Japan note will not be used for transactions. While such a case might not occur in major countries, many of you might have an experience in which a seller does not sell the product in the home currency or asks to use dollars for the purchase. In these cases, while the home currency might be legal tender, it might be a currency that people cannot receive with a sense of security, because of various factors. For example, there might be too many counterfeit notes to engender confidence, there might be high inflation and a risk that the value of banknotes will decline tomorrow, or the country might be experiencing a financial crisis and people cannot deposit their money with a sense of security. The mission of a central bank is to avert these things. Put more specifically, a central bank's mission is to achieve "stability of the value of money." In detail, first, a central bank's most intrinsic task is to issue banknotes and faithfully manage them so that counterfeits or dirty banknotes do not circulate. The second task is to stabilize prices. Since fluctuations in prices will make rational economic calculation difficult and impair the efficiency of resource allocation, they will hamper economic growth and, to start with, threaten social stability. The third task is to maintain financial system stability. Bank runs and the absence of trade in the financial markets occur when financial system stability is eroded, and its grave effects are what I explained earlier. A central bank's mission is to ensure that money necessary for economic activity can be circulated to every corner of the world through the tasks I have just described. In a nutshell, the mission is to "ensure that people can use money with confidence," namely, to achieve "stability of the value of money." While it goes without saying that this state cannot be achieved solely by a central bank, and the regulatory and For the operations of the Bank, see "Functions and Operations of the Bank of Japan," edited by the Institute for Monetary and Economic Studies, Bank of Japan. supervisory authorities as well as private financial institutions also play important roles, the role played by the central bank is extremely important. While you may have read about this in a textbook or have some prior knowledge about this mission of a central bank, let me emphasize two things for thorough and accurate understanding of the mission of a central bank. First is the importance of credibility in a central bank. A central bank's ability to control interest rates and to supply ample funds derives from the fact that nobody will refuse acceptance of money issued by the central bank, namely, banknotes and the central bank's current account deposits. Through experience, modern nations have recognized the importance of credibility, established an organization that crystallizes this credibility, and entrusted the issue of money to that organization. In other words, even if an organization called a central bank has been established, a central bank will not be able to control money properly if its credibility is insufficient, and thus the central bank itself must strive to win such confidence. Second, when a central bank tries to pursue its public purpose of the stability of money, it will do so not by law or administrative order but through transactions in the market. Earlier I explained the Bank's measures taken in response to the global financial and economic crisis, and all these measures were not forced by law and administrative order but were carried out in the form of market transactions. Be it control over interest rates or provision of funds, they were conducted mainly by purchasing government bonds from the market or lending to financial institutions. As for CP, the Bank purchases it from financial institutions by conducting auctions. Because of this, a central bank is called the "bank of banks" or the entity "in the market." V. The role of Law How and in what form are law and the legal mind useful for the Bank to carry on its mission? I will discuss three points. Democracy and central bank independence: issues from the viewpoint of public law The first point is from the viewpoint of public law: the issue of "democracy and central bank independence." "Independence" means "to decide on one's own with a decision that is not reversed by others" (Chart 14). Now, why is a central bank granted independence in a democracy? In general, monetary policy affects economic activity and prices after a time-lag. Against such a backdrop, if monetary policy is conducted, based only on judgments about short-term economic and financial conditions, it will likely lead to a situation in which economic stability is impaired, as experienced during the previous inflations and the bubble. One major cause of the current global credit bubble was the prolonged low interest rates. When the problem started to grow in 2003 through 2004, the focus of many policy authorities and economists in the United States and Europe was on neither inflation nor the bubble but rather how to stave off global deflation. While people are weak in that they are likely to be influenced by short-term interests, they are also equipped with wisdom that allows them to establish a system in advance to avoid a situation that is undesirable from a medium- to long-term perspective. This is the conception of central bank independence, which entrusts the conduct of monetary policy to an organization that makes judgments based on expertise from a medium- to long-term perspective.6 Of course, there is no all-encompassing For the legal issues on central bank independence, see "Kohotekikanten kara mita Nippon Ginko no Gyomu no Hotekiseikaku to Un'ei no arikata (Legal Characteristics and Operation of the Business of the Bank of Japan from the Viewpoint of Public Law)" (September 2009, contained in Kin'yu Kenkyu [Monetary and Economic Studies], Vol. 18, No. 5) and "Kohotekikanten kara mita Nippon Ginko no Soshiki no Hotekiseikaku to Un'ei no arikata (Legal Characteristics and Operation of the Organization of the Bank of Japan from the independence. The objectives of a central bank are clearly stipulated in the central bank act, and the governor and other central bank executives are appointed according to democratic procedure. Moreover, it is required by law to disclose the policy decision process of a central bank (Chart 14).7 In the current crisis, central banks around the world including the Bank of Japan have acted extremely vigorously, including taking extraordinary measures in rapid sequence. A series of measures have been substantially effective in stabilizing the crisis. The prompt implementation of these measures in response to the changes in financial market conditions was only made possible because each central bank expeditiously decided policies according to its own judgment and the temporary measures could be terminated when they became unnecessary. The independence of a central bank is rarely questioned when it conducts policy using orthodox measures and operations. However, when a central bank had to take extraordinary measures in the current crisis, it was quite difficult for the central bank to decide what measures to take and to what extent based on what rationale. Taking the outright purchase of CP, for example, the point of contention was whether a central bank should go beyond the territory of liquidity provision to the financial markets as a whole and bear credit risk for individual firms. If the CP-issuing firm goes bankrupt, the Bank of Japan will incur losses, which results in a burden on taxpayers. A question naturally arises whether such a measure should be carried out as a fiscal policy measure by the Diet and the government in line with the decision-making process in a democracy. We had repeated serious discussions on that point. As explained earlier, as for the right or wrong of carrying out the measures, we decided that the extraordinary measures would be necessary to fulfill the mission of a central bank under an extraordinary situation of extreme malfunctioning of the capital market. On this basis, we paid due attention to the system design so as to minimize the side effects (Chart 15). For example, in purchasing the CP, we set conditions so that the incentives of financial institutions to sell CP to the Bank would decline as the functioning of the market recovered. Moreover, we limited the purchases to the CP issued by firms whose ratings were above a certain threshold. Credit risk was of course not zero, but we judged that it was necessary to be borne in order to achieve the purpose and effects of the policy. While it is important that a central bank respond flexibly according to economic and financial conditions in light of the objectives stipulated in law, it becomes quite difficult for a central bank to draw a clear line between what it "should do" and "should not do," given that it is granted the capability of issuing currency unlimitedly. This is important as an issue of decision making in a democracy. Our task is to fulfill our mission by utilizing the resource of "confidence" as effectively as possible, while being cognizant of the mission of a central bank and the position of a central bank in a democracy, and thus it is associated with difficult judgments.8 Viewpoint of Public Law)" (September 2000, contained in Kin'yu Kenkyu [Monetary and Economic Studies], Vol. 19, No. 3). Both are the reports by the study group on central banks from the viewpoint of public law and published on the web site of the Institute for Monetary and Economic Studies of the Bank (available only in Japanese). For the governance of the Bank, see "Kohotekikanten kara mita Nippon Ginko no Soshiki no Hotekiseikaku to Un'ei no arikata" (supra Footnote 6). For the basic ideas of the Bank in these regards, see "Outright Purchases of Corporate Financing Instruments" (Bank of Japan, January 2009). Innovation in central banking business: issues from the viewpoint of private law From a slightly different angle, I will talk about the second legal point at issue. I have mentioned that a central bank achieves its public objective of currency stability through transactions in the market. In doing so, the services provided by the central bank must be attractive. Therefore, the central bank has been trying various measures in accordance with the changes in the economic and financial environment, and I will explain the role law has been playing in that respect, mainly focusing on private law. Earlier I explained the introduction of a scheme to provide funds against foreign government bonds as eligible collateral – a cross-border collateral arrangement. In order to put the scheme into practice, there were numerous legal issues to be cleared. First, a question of private international law: which country's law would be applied in creating the security interest over foreign government bonds physically located in foreign countries. Second, a question of the legal framework for collateral in foreign countries: how to create the security interest and how to exercise the security interest in case of default. Third, a question of international financial business practices: what kind of contract should be concluded with a counterparty. While it is a difficult job to examine each country's legal system and hammer out responses, it is nevertheless worth challenging and it is fascinating. I just mentioned "foreign government bonds physically located in foreign countries", but in fact government bonds of Japan and other major countries are dematerialized and transfers and pledges of these bonds are made by making entries into securities accounts. In the Bank of Japan's cross-border collateral arrangement, with the transfer of a country's government bond to a securities account held with the country's central bank, the security interest will be created based on the country's law. While details vary by country, such a scheme has enabled financial institutions to efficiently use securities, wherever they are physically located, as collateral to borrow necessary funds from various central banks around the world. Such innovations are necessary not only in the area of legal knowledge but also in the areas of the payment and settlement system and computer system. The Bank runs a system called the Bank of Japan Financial Network System (BOJ-NET), and transactions between financial institutions are settled in that system. When the BOJ-NET is used to settle the sale and purchase of securities, there is a scheme to simultaneously carry out the delivery of the securities and payment of funds; it is called delivery versus payment (DVP). Through DVP, default risk associated with the time difference between delivery of securities and funds can be mitigated. Building on the idea of DVP, extending the operating time of the BOJ-NET and, for example, creating a time zone that overlaps with the operating time of other central banks' system would facilitate simultaneous settlement between the yen and the U.S. dollar and make it possible to meet other various settlement needs. Recognizing these possibilities, the Bank has started to consider building a new system. As such, to make the flow of funds efficient and safe by improving the fund provisioning framework and payment system is an important job for a central bank. By way of these innovations, the central bank has always been striving to make its services more usable and attractive. Such efforts to improve services are essential for maintaining confidence in a central bank. From the viewpoint of a central bank, the progress in globalization means that central banks are entering competition in terms of providing high-quality services. Financial system stability and international legal issues Lastly I will take up as the legal point at issue the role that law is playing in financial system stability, especially in an international aspect. Safeguarding the stability of the financial system is not the same as preventing individual financial institutions from going bankrupt. In the market economy, the principle is that financial institutions, like other firms, will also undergo selection if they fail in their management. If there is an overly high sense of security that the government and the central bank will bail out financial institutions even if they fail in their management, financial institutions' self-discipline will be lost and they will pursue excessive risks, thereby destabilizing the financial system. This is the so-called moral hazard problem. What is important, even if individual financial institutions go bankrupt, is to minimize the effects on other financial institutions and maintain the stability of the financial system as a whole. Let me take up again the case of Lehman Brothers as an example (Chart 16). In order to smoothly pursue the insolvency proceeding of an internationally active financial institution like Lehman Brothers, it is essential to have coordination between central banks and the supervisory authorities. To begin with, if insolvency during operating hours, namely "intraday insolvency," occurs amid the existence of a time difference, the effects will be grave. In order to avoid this, it becomes necessary to set a proper timing for insolvency. In addition, so as not to complicate the relationship of debts and claims due to new transactions, a business suspension order might become necessary. In the case of Lehman Brothers, in response to the U.S. headquarters' filing for Chapter 11 on September 15, 2008, the Financial Services Agency issued a partial business suspension order to its Japan affiliate. September 15 was a national holiday in Japan. On the ensuing first business day, September 16, Lehman Brothers' Japan affiliate applied to the Tokyo District Court for the civil rehabilitation procedure, and the court decided on the start of the procedure on September 19. The Bank of Japan implemented measures as a central bank to secure financial system stability. Since the Bank was also a creditor of Lehman Brothers, the Bank needed to carry out the measures by gaining the understanding of the court. Moreover, on the settlement front, onesided default risk was mitigated through the yen-dollar PVP by the CLS and securities DVP by the BOJ-NET. Furthermore, settlement proceedings and loss-share rules in case of insolvency were agreed in advance among market participants, and these functioned well. Because of these various responses, payment and settlement of domestic transactions were conducted generally smoothly in Japan. While it might sound unusual, it is of critical importance that bankruptcy be conducted skillfully without causing any trouble to the financial system as a whole. In the current financial crisis, Lehman Brothers filed for insolvency, while many financial institutions in the United States and Europe were nationalized or received public capital infusion. In response to this situation, the reflection emerged that a framework for orderly disposal of a financial institution with a significant impact on the financial system was insufficient.9 Since the framework for disposal was insufficient, a case occurred such as Lehman Brothers – which could not be disposed of while maintaining important operations and which was forced to liquidate – or, adversely, cases occurred in which the authorities judged part of financial institutions as "too big to fail," and eventually many taxpayers had to bear the burden. If the institutions that should fail do not go bankrupt, moral hazard will intensify and the vitality of the financial system and the economy will be eroded from a longer-term perspective. The ability to dispose of failed financial institutions in an orderly fashion is quite a critical factor in strengthening the financial system. In particular, with respect to internationally active financial institutions that are likely to be subject to the problem of "too big to fail," difficult legal issues, such as insolvency laws of various countries and the legal theory of adjustment among these laws, need to be cleared. In this regard, active debate has begun among central banks and the supervisory authorities around the world.10 In the case of Japan, to manage the increasing failures of financial institutions after the collapse of the bubble economy, laws prepared in and after the late 1990s enabled orderly disposal of failed financial institutions. See "Heisei Kin'yu Kiki eno Taio – Yokinhoken wa ika ni Kino shitaka (Responses to the Heisei Financial Crisis – How Deposit Insurance Functioned)," edited and authored by the Deposit Insurance Corporation of Japan, November 2007 (available only in Japanese). For discussions regarding the resolution process of failed internationally active financial institutions, see "Report and Recommendations of the Cross-border Bank Resolution Group," a consultation paper published by the Basel Committee on Banking Supervision (September 2009). VI. Professional life at the Central Bank Thus far, I have explained the role and tasks of a central bank from the viewpoint of "law and economics". However, I feel that such an explanation may not be sufficient to convey a sense of the actual role of a central bank and the essential factors in achieving financial and economic stability. Judging from my own experience of my student days, perhaps the most difficult part to understand might relate to the meaning of "working." Therefore, to wrap up this lecture, I will discuss five aspects of what "working" means in the case of a central bank. Raison d'être of public service First, there is the significance of public business. As I have repeatedly mentioned in this lecture, the mission of a central bank is to stabilize the value of money. When you think about it, a central bank is an extremely complex entity. On one hand, it values the market mechanism very highly. On the other hand, as the experience of the current financial crisis shows, it sometimes intervenes in the market in order to prevent the collapse of the financial system. Conversely, it also put the brakes on the excess of the market and financial and economic activities. While these actions are sometimes unpopular, there must be some organization that plays this type of public role in order to achieve sustainable growth in the economy. Importance of broad knowledge Second is the importance of broad knowledge. At the beginning of this lecture, I talked about my personal experience. After 36 years of experience at the central bank, if I am asked, "Which is important, knowledge of law or that of economics?" I will come to a very commonsense conclusion: in the work of a central bank, knowledge of economics, of law, and of broader areas is all necessary. I believe that the best part of economics is that it always strictly analyzes human behavior from a viewpoint of incentives. Without such analysis, we cannot conduct monetary policy and system design with respect to financial regulation and supervision. However, at the same time, if "policy discussion" based on such economic analysis is not taking due account of the supporting rules or contracts, things will not practically work. In this regard, legal knowledge is quite important.11 Importance of business operations Third is the importance of business operations. When the policy of the Bank of Japan is taken up in the newspapers or on television, in many cases the focus is its "policy," such as raising or reducing interest rates. However, a consideration of monetary policy requires much more than examination of the target level for the interest rates. The interest rates are induced through banking operations including the sale and purchase of bonds and bills as well as lending to financial institutions. These operations entail consideration of various factors such as from whom and under what conditions the Bank will purchase, how much liquidity the Bank will provide and for how long, and what kind of scheme should be prepared for settlement. When discussing policies, therefore, understanding of business operations is indispensable. In particular, as was the case in the current crisis, when it becomes necessary to respond in ways that differ from those in normal times, it becomes important to take due consideration of business operations. The difference such a consideration would make in the effects and risks associated with policies are just as I have explained. Based on these understandings, the central banks of the major countries are encouraging and supporting examination by legal experts, including legal scholars and practicing lawyers, of legal issues related to financial transactions. The Bank serves as the secretariat of the Financial Law Board (FLB), a Japanese organization that examines such legal issues. For information on the purpose, activities, and other details concerning the FLB, see its web site. At the same time, we should also recognize that discussing policy without a proper perspective does nothing but harm. The real world is not so simple that gathering all information from the field, namely micro information, will lead to an understanding of the total, and policy cannot be judged from the viewpoint of practical operations alone. To understand the complex reality, support provided by theory is required, and a macro approach to the core of the issue taking account of historical experiences is also indispensable. Significance of working in an organization Fourth is the significance of working in an organization. When a central bank conducts policy, much work in collaboration is required. To begin with, the assessment of the economic situation, which is the presumption of policy formulation, is backed up by micro economic research and information from the financial front, as well as macro statistics and economic theory. In addition, in formulating a policy based on the assessment of the situation, a viewpoint on how to implement through banking operations is indispensable. During the process, many people who have various kinds of expertise and experience in economics, finance, law, and information technology are involved. In addition, they build up a policy by understanding their colleagues' jobs and by cooperating with each other. While the decisionmaking body of the Bank of Japan is the Policy Board, consisting of nine members including myself, policy cannot be made by the nine members alone. It is essential to have the wisdom and experience of the many staffers who support the Policy Board members. The experience and wisdom of a single person are limited. Cooperation between many people with different skills, expertise, and experience helps achieve the goal, and the give and take during the process of cooperation will lead to solutions of future problems. These things are what make the existence of an organization significant. Working in an organization thus shows the importance of "institutional memory". While institutional memory is accumulated in any type of organization, it becomes particularly important in the case of a central bank, since the central bank's objective is to ensure economic and financial stability from a longer-term perspective. In this regard, what I always feel when I take part in international conferences and visit central banks overseas is that central bankers all have something in common. It appears as if a central bank's DNA – which means "considering based on a medium- to long-term perspective," "placing great importance on the market," "examining in terms of money market operations and business operations," and "maintaining the culture to formulate policy as an organization" – is shared among central bankers. In the current global financial crisis, the existence of this common DNA enabled central banks to cope in tandem with the crisis by means of close cooperation. Importance of a flexible approach to cope with changes Fifth is the importance of a flexible approach to cope with changes. Economic and financial conditions keep evolving, and a central bank faces new challenges every day. To cope with the new challenge, inputs from various areas are indispensable. For example, in the past, a run on a bank suggested depositors with their deposit books queuing up in front of a bank. In the current financial crisis, however, a run totally different from the past took place; it might be termed a "market-type run." In the early part of this lecture, I explained that mutual confidence between financial institutions collapsed and financial institutions became hesitant to make transactions in the markets. This happened not only in uncollateralized markets but also in collateralized transactions. One example was a repo transaction. The repo market is where participants temporarily sell or lend bonds such as government bonds to receive funds in exchange (Chart 17). For securities firms that buy and hold a large amount of government bonds, the repo transaction has been an important measure for funding. Since the repo transaction is an exchange between securities such as government bonds and funds, it is a collateralized transaction. In such a transaction, since the value of collateral changes as the price of bond changes, there are accordingly periodic exchanges of funds. For example, if the price of a bond declines substantially, additional collateral equivalent to the amount of price changes must be financed somewhere and handed to a counterparty. In normal times, this amount can be financed by cash on hand or borrowing from financial institutions, but in times when confidence has collapsed, it might not be financed. In such a case, some might sell government bonds they have on hand and try to obtain funds. If such activity increases, bond prices will decline further and the additional cost of repo transactions will increase. According to such drastic changes in financial and economic conditions, a central bank continually must devise approaches using flexible thinking. Thus, while some might associate a central bank with an old-fashioned image, it is full of innovation. VII. Concluding remarks Looking back on when I joined the Bank of Japan 40 years ago, I virtually knew nothing about the tasks at the Bank. Since then, I have experienced the excitements and difficulties in the professional life of an organization like the Bank, with its public objectives. I have seen a long list of major events since joining the Bank: floating of the yen, oil shocks, the bubble, the bursting of the bubble and the ensuing financial system turmoil, and the current global financial crisis. At all times, what remains unchanged is that the ultimate mission of a central bank is to safeguard the stability of the value of money and the confidence in the currency. The current global financial crisis is something that almost all the policy authorities and economists "knew" from a historical standpoint, but never imagined that they would actually experience. In response to such a situation, central banks including the Bank of Japan have hammered out various innovative measures. As I look back on the 40 years since I started to work at the Bank, and look out at you as you attend this lecture, I cannot help wondering what will happen during the coming 40 years. A new type of crisis is quite imaginable. Preventing the outbreak of such a crisis, or – if such a crisis unfortunately occurs – minimizing the effects to achieve economic stability is a challenging task, and students like yourselves who are going out into society cannot remain completely immune from such challenges, regardless of your areas of work in public organizations, private firms, or as academics. All of you have been studying law and might be hoping to utilize law to contribute to the world. There are many jobs such as the legal profession and legal departments where knowledge of the law can be utilized. While all of those jobs are no doubt important, it would be more than I can dream of if you also recognize the challenging and unique workplace that is a central bank. I would be delighted if my lecture today has made you feel closer to the presence of the central bank. Thank you.
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Speech by Mr Hirohide Yamaguchi, Deputy Governor of the Bank of Japan, at the Retail Finance Strategy Conference 2009, Tokyo, 25 November 2009.
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Hirohide Yamaguchi: Challenges for Japanese financial institutions after the financial crisis Speech by Mr Hirohide Yamaguchi, Deputy Governor of the Bank of Japan, at the Retail Finance Strategy Conference 2009, Tokyo, 25 November 2009. * * * Introduction Thank you for having me at the Retail Finance Strategy Conference 2009. It is my great honor to have an opportunity to speak in front of you who have been in the front line of business. Japanese financial institutions have been significantly affected by the current global financial crisis. The impact has spread over to the area of retail banking through deteriorating the business performance of small- and medium-sized firms and sluggish sales of mutual funds. I will talk today about my views on the challenges for Japanese financial institutions after the current crisis, and offer my thoughts on approaches to meeting the challenges. I hope my speech can shed new light on your thinking of retail banking strategies. I. Looking back at the global financial crisis over the past year It is more than a year since the failure of Lehman Brothers in the autumn of 2008. Once turbulent global financial markets have recently regained stability mainly due to ample liquidity provision by central banks around the world. The global financial system has also been gradually regaining stability, thanks to, among others, the effects of injections of public capital into major U.S. and European financial institutions. Meanwhile, the global economy deteriorated rapidly up to the spring of this year, but has been on a recovery path supported by policy responses on the fiscal and financial front as well as firms’ efforts in production adjustment. To start with, the crisis resolution is only halfway through both on the economic and financial fronts. The balance sheets of financial institutions in the United States and Europe have been deteriorating, including loan assets, and the completion of their adjustments are likely to take some more time. I would say that the global financial system as a whole still retains vulnerability. Arguably, the essence of the current global financial crisis is the generation and burst of the credit bubble. While many reasons have been pointed out, I will point out particularly these three. First, as accommodative financial environment continued on a global scale up to the middle of the 2000s and price stability and high economic growth were achieved, many “excesses” were generated in the risk-taking activity of various economic entities. On the real economic activity front, for example, against a backdrop of the sustained rise in housing prices, the household sector in the United States increased borrowing and significantly increased consumption. On the financial front, new types of transactions such as securitized products and derivatives prevailed, and leverage increased. Such “excess” in real economic activity, asset prices and financial markets influenced each other to generate further “excess.” Once the credit bubble burst, the unwinding of the leverage began, and liquidity in the global financial markets rapidly contracted. On the real economic activity front, firms were forced to curtail aggressively their production due to the pile up of inventories, and the global economy contracted significantly. Second, as what is the other side of same coin of the macro aspects that I have just mentioned, the micro financial institution behavior also went too far under inadequate risk management or overconfidence. Since the turn of the 2000s “the originate-to-distribute model” became common among major financial institutions in the United States and Europe, and it has been said that, in such a process, loan screening lacked substance at financial institutions that were the originators of loans. Financial institutions that were supposed to have transferred credit risk through distribution were forced to repurchase securitized products after the crisis occurred, and were reminded of a major misconception about their risk recognition at the time of distribution. Even as for liquidity risk, in retrospect, it was revealed that financial institutions significantly underestimated the market liquidity, mainly of securitized products. Such lack of proper risk management and others led to financial institutions’ excessive risk-taking activity. However, once the unwinding of leverage began in tandem with the outbreak of a financial crisis, financial institutions in the United States and Europe incurred massive losses, which made their risk-taking stance rapidly cautious. That was typically shown in the current decline in lending of financial institutions in the United States and Europe. Third, it cannot be denied that somewhat slow responses by the policy and supervisory authorities in the United States and Europe to the generation of the credit bubble preceding the crisis also eventually amplified the current crisis. One reason for that was the difficulty the policy authorities and supervisory authorities had faced in identifying the location and the size of risks, due to the expansion of the so-called shadow banking by insurance firms, monoline companies, and hedge funds. That was one of the factors behind the recent review of regulatory and supervisory systems overseas. On the monetary policy front, it can be pointed out that central banks had not organized their thoughts with respect to the containment of the credit bubble, including how a central bank should respond to asset price developments. Namely, while there was a standpoint to argue that “a central bank should not apply monetary policy to asset price developments but should carry out aggressive monetary easing after the burst of a bubble,” there was another standpoint to argue that “considering the magnitude of the adverse impact on the economy following the burst of a bubble, a central bank should conduct monetary policy to avoid the generation of a bubble.” In short, there was no consensus among the central banks around the world on how to ensure macroprudence. Based on the current financial crisis, central banks have commonly recognized the importance of analyzing and assessing the financial system as a whole by eyeing the relationship between the real economy and the financial system from a viewpoint of macroprudence. And, how to cope with asset prices on the monetary policy front is expected to be further discussed in the future. Those are the issues that I particularly deem important concerning the generation and burst of the current credit bubble. In the U.S. and European financial markets, there have been lively discussions on the rebuilding of financial institutions’ business model, taking into account the experience of the current crisis. Many may feel it uneasy to apply directly the discussions overseas on financial institutions’ business to Japanese financial institutions. Such feeling might come from the significant difference in how the current crisis arose in the United States and Europe, and in Japan. Namely, for Japanese financial institutions, unlike the U.S. and European financial institutions, the first-round effects associated with the turmoil in structured product markets have been relatively marginal while the second-round effects associated with the economic downturn and the plunge in stock prices have been profound. Now I will talk about the characteristics of Japanese financial institutions and the challenges for them by also referring to the results of the analyses made in the Bank of Japan’s biannual Financial System Report. II. The present state of Japanese financial institution management Characteristics of Japanese financial institutions’ management Japanese financial institutions and financial institutions in the United States and Europe are the same in terms of exerting the important financial intermediation function, but quite different in terms of business model and risk-taking stance. First, in Japan, deposits are dominant in the financial assets of the household sector, and at Japanese financial institutions, both the major banks and the regional banks, traditional commercial banking that focuses on deposit-taking and lending still carries much weight. As previously mentioned, financial institutions in the United States and Europe have recently expanded the originate-to-distribute model, and, in terms of profit, have been increasingly relying on the fee business and the trading business. Japanese financial institutions, mainly the major banks, have been strengthening investment banking and asset management businesses. However, deposit preference in the household sector has been deeply rooted, and the pattern that financial institutions using their deposits as a source of loans and investments, mainly in government bonds, has not changed much. As a result, while the ratio of borrowing from financial institutions to firms’ aggregate funding except for stocks is about 20 percent in the United States, that ratio reaches 50 percent in Japan. Also from that point, you can see that the flow of funds through deposits and lending in Japan is still dominant. Second, in terms of transaction relationship between financial institutions and customers, while financial institutions are gradually shifting to focus on the profitability of individual transactions, the stance of building a long-term stable business relationship based on overall profitability appears to persist. Such focus on the long-term transaction relationship is by no means unique to Japanese financial institutions, and is also observed in U.S. regional banks. However, in the United States, such business relationship with customers seems to have been changing with the expansion of securitized markets. In addition, in the area of small firm lending, small business loans that simplify the screening process have increased mainly in major U.S. banks. That can also be considered as an expansion of lending business that is not based on the long-term customer relationship. Also in Japan, the long-term relationship between financial institutions and customers once called a main-bank system has been gradually waning and transactions that attach importance to individual profitability have been emphasized. Small business loans were also once actively used in Japan. Financial institutions have come to provide fine-tuned services to depositors according to their outstanding amount of deposits and the frequency of the use of services, and have not necessarily consider their profitability in the context of long-term transaction relationship. However, such changes in the transaction relationship proceed only gradually and it appears that the financial institutions’ basic stance of pursuing the long-term stable transaction relationship with customers has not changed substantially. For example, the practice of cross-shareholdings between financial institutions and large firms still remains, albeit declining in size. It seems that the regional financial institutions have also been focusing on the long-term transaction relationship with local firms as in the past. Third, in terms of risk-taking, Japanese financial institutions generally appear to have been maintaining a cautious stance. Behind that was a powerful effect of Japanese financial institutions’ experience of incurring massive losses in the aftermath of the bursting of the bubble in the 1990s. One of the lessons learned from the bubble and its burst was the size of risk of concentrating credit on specific industries or firms. While it was difficult for some financial institutions to pursue active risk-taking until they completed their repayment of public funds, I believe that Japanese financial institutions as a whole generally appear to have been maintaining a cautious risk-taking stance based on the experience I have just mentioned. Effects of the financial crisis and challenges for Japanese financial institutions As seen above, Japanese financial institutions faced the current global financial crisis without being able to change substantially the existing management characteristics. As a result, the first-round effects of the crisis, namely the losses stemming from investments in U.S. securitized products and originate-to-distribute-type operations in the U.S. and European financial markets, has remained relatively limited as mentioned before. The second-round effects brought about by the current financial crisis, namely, the losses stemming from the economic downturn and the plunge in stock prices have by no means been limited. Net income of Japanese financial institutions in fiscal 2008 made an about-turn to mark net losses of about two trillion yen from net profits of about two trillion yen in fiscal 2007, due mainly to the increase in credit costs and losses related to stocks. In that regard, the aforementioned characteristics of Japanese financial institution management seem to have rather worked in an adverse way to the deterioration in business performance. In other words, the current crisis has highlighted the basic challenges inherent in Japanese financial institution management. Let me elaborate those challenges. First, low profitability of financial institutions. While Japanese financial institutions’ profits recovered significantly after the middle of the 2000s, it was mainly attributable to the reversals in loan-loss provisions, thanks to the progress in the disposal of impaired assets and economic recovery. For example, the sum of net income of Japanese financial institutions for the past 20 years is in the red. While the sum includes significant losses stemming from the disposal of impaired assets after the burst of the bubble, the net income of Japanese financial institutions remains quite low even if those losses are excluded. The major reason for such low profits is the low interest income. Looking at the interest rate margins on loans (i.e., the interest rate on lending minus the interest rate on deposits), which is one component of interest income, for the past 20 years, the margin has been five to six percent on average for U.S. banks, while it has remained at slightly below two percent for Japanese financial institutions. The main reason behind such low interest rate margins of Japanese financial institutions is attributable to the fact that many financial institutions have basically been consistently in the interest rate competition as they compete with each other in the relatively homogenous commercial banking business with an aim to obtain a long-term stable transaction relationship. In short, the difference in business model by financial institutions is hardly observed. According to the analysis of the lending market in Japan, many financial institutions tend to enter the regions that have a large lending market, thereby intensifying competition. By contrast, in the U.S. market, there is no significant correlation between market size and market concentration, which suggests that certain segregation among financial institutions might be in place. While it is not clear why such a segregation was possible, it is clear that the segregation enabled financial institutions to avoid the needless interest rate competition. Of course it is not the case that Japanese financial institutions themselves have not been doing anything to cope with such low profitability. Signs of expansion in the investment banking business, including M&A business, have also been continuing in Japan. Small business loans were once actively promoted. However, since credit costs increased significantly, many banks have recently been forced to downsize or withdraw from the small business loan operations. As for household asset management, the expansion of over-thecounter sales of mutual funds and insurance has been pursued. Moreover, at the major banks, the efforts to bring consumer credit companies, credit card companies, and consumer finance companies under the banks’ umbrella were temporarily intensified. However, the profits from those affiliated companies have been sluggish, partly due to the changes in the environment they are in. After all, the fruits of pursuing new businesses have not been sufficient so far, and, at present, the new businesses have not contributed in a significant way to improving the profitability of financial institutions. Second, Japanese financial institutions’ profits are subject to the fluctuations in credit costs and stock prices. In particular, as operating profits from the core business have been remaining low, a significant increase in credit costs and losses on stocks might immediately bring periodical income into the red. In fact, eight times in the past 20 years, the sum of credit costs and losses related to stocks reached a level more than that of operating profits from the core business. While the level of credit costs fairly declined, reflecting the completion of the disposal of impaired assets, it started to rise again in fiscal 2008 due to the economic downturn. In addition, the outstanding balance of financial institutions’ strategic cross-shareholding was reduced almost by half during the disposal process of impaired assets in the early 2000s for the major banks, and remains almost unchanged since then. That suggests that the practice of cross-shareholding between financial institutions and firms remains, and, at the same time, the current outstanding amount of shareholding is still a factor in inducing large swings in financial institution profits. While the challenges cannot be met easily, I expect financial institutions to consider them now as a golden opportunity and step up their efforts in order also to maintain and further arouse the vitality of Japan’s economy. III. Approaches to meet the challenges Strengthening capital base consistent with risks Next, I will offer my views on what kind of approaches might be necessary for meeting the challenges. First, strengthening capital bases that are consistent with the risks held by financial institutions. The review of the regulatory framework including the capital adequacy ratio for financial institutions has been discussed globally. It is expected that an initial draft of a new regulatory system will be presented between the end of this year to the beginning of next year, and after conducting quantitative research on the influence of a new system, a final draft will be completed by the end of 2010. It is necessary to carefully examine how a new regulatory system would affect the financial system and real economic activity. However, it is critical for individual financial institutions themselves, independent of the discussions on such a regulatory framework, to strive to strengthen their capital bases that are consistent with the risks they hold. After all, capital is the last resort as a buffer to absorb losses. What became a catalyst for the global financial system to gradually regain stability after the current crisis were the efforts by U.S and European major financial institutions to restore their capital through receiving public capital or raising private funds in the markets. Concerning Japan’s financial system as a whole, macro-stress tests conducted in the Bank’s Financial System Report showed that Japanese financial institutions’ capital bases are not likely to decline substantially even in the situation where severe future macroeconomic conditions are assumed. However, as mentioned earlier, in the case of Japan, there is the problem that banks’ profits tend to fluctuate according to economic developments, which lead to changes in capital. In addition, if financial institutions pursue a new business strategy to meet a variety of needs from firms and households, capital bases that can tolerate risks of a certain degree need to be enhanced. Both the major banks and the regional banks have recently been reinforcing their capital bases, which the Bank regards could lead to ensure soundness of individual financial institutions as well as the stability of the financial system as a whole. Appropriate risk management Second, the importance of appropriate risk management. For a financial institution, risk management is essential in ensuring management soundness and maintaining the smooth financial intermediation function as well as a key to ensuring profits. In terms of credit risk management, Japanese financial institutions have been improving their screening skills, based on the experience of the bubble period during the 1980s, and have made fair accomplishments. However, the deterioration in firms’ business performance triggered by the current financial crisis has progressed at an unprecedented pace. Taking that into account, it becomes important for financial institutions, in addition to improving their screening skills, to strengthen follow-up management, and further strive for supporting corporate rehabilitation. Moreover, the finely-tuned setting of lending interest rates according to credit risks continues to be an important challenge. In terms of market risk management associated with stockholdings, the size of strategic cross-shareholding will be basically left to firms’ and banks’ business strategies. However, the current market risk associated with stockholdings of Japanese financial institutions as a whole remains to be high relative to capital bases, and a steady reduction in the amount of that risk is no doubt a critical challenge for financial institution management as well as for the stability of Japan’s financial system. Building a business model to strengthen profit base – focusing on retail banking Third, building a business model to strengthen the profit base. While I will focus on the topic of today’s speech, retail banking, reinforcement in the area of wholesale banking is also essential for strengthening the profit base. Retail banking could provide higher value-added services by managing it in an integrated way with wholesale banking. For the major banks, how to formulate coordination between wholesale and retail banking would be one of the keys to rebuilding their business model after all. Operations related to deposits, payment and settlement, and asset management To that end, first I will take up the role of operations related to deposits, payment and settlement, and asset management. After the current financial crisis, a phenomenon to be seen as “back to basics” of financial operations has been occurring in the United States and Europe. Proprietary trading of complex products, such as securitized products and derivatives, has complicated the risk profiles of financial institutions and made risks difficult to manage. Based on such recognition, a move to return to the traditional business based on customer transactions has been emerging. The move includes a re-evaluation of traditional businesses related to deposits and payment and settlement while taking into account a viewpoint of improving the management of liquidity risk. Those businesses are, so to speak, the areas Japanese financial institutions have been good at. One question for financial institution management in Japan is whether the costs associated with maintaining deposit bases are commensurate with the profits. Retail banking is associated with a variety of unique factors that lead to an increase in costs, including ATM that operates 24 hours. Meanwhile, to charge fees for the current deposits whose balance dropped below the required minimum balance is not gaining customers’ understanding. While how to balance the costs and profits is an important management judgment, it would be absolutely necessary for financial institutions to avoid the possibility of running below break-even. As financial institutions are expected to provide fine-tuned services to households reflecting their outstanding balance of deposits and the degree of use of services, it would be necessary to check the balance between the quality of services and the cost sharing. In addition, if one assumes a situation in which households’ asset accumulation further progresses and their asset management diversifies, it would be essential to enhance the services to support households’ asset management. Such services are currently provided in the form of over-the-counter sales of mutual funds and insurance, and asset management services. By properly gauging the needs of customers and enhancing the provision of services, I believe it important that the fee business steadily takes root. Personal loans Second, the role of personal loans. In Japan, housing loans have overwhelming weight and accounts for about 20 percent of the financial institutions’ total lending. Housing loans in Japan have been increasing steadily even under the current financial crisis. The problem is its profitability. According to the Bank’s analysis, the profitability of Japanese financial institutions’ housing loans has been consistently declining recently. For example, if the profitability of housing loans during the life of a loan that was lent in fiscal 2003 and fiscal 2007 is compared on a present value basis, it will decline by about six percentage points. If the default rates rise significantly in the future, it cannot be denied that banks’ profits will plunge. The profitability of housing loans also warrants careful monitoring. In addition, consumer loans such as card loans and car loans are an area where potential needs exist over time. With a view to its potential, the major banks have been increasing their capital subscription to consumer credit, credit card, and consumer finance companies. As explained earlier, those affiliated companies have not contributed to increasing the profits of financial institutions, while the future developments in the area of consumer loans warrant attention. Lending to small- and medium-sized firms, and provision of risk money Third, fund provision to small- and medium-sized firms. Firms’ funding conditions rapidly deteriorated from the autumn of 2008 to the beginning of 2009, and have been recently improving, partly due to the recovery of CP and corporate bond markets. Many small and medium-sized firms still view their funding conditions as tight, and the Bank considers that the smooth fund provision to small and medium-sized firms continues to be an important challenge for corporate finance in Japan. Looking at the future of Japan’s economy, how to provide risk money to small- and mediumsized firms with high technology would be a challenge for the financial system. In that case, it becomes important to apply part of households’ ample financial assets to risk money. In Japan, while the importance of venture capital has repeatedly been argued, it has not grown in a significant manner so far. Providing risk money smoothly to firms that have a possibility of leading Japan’s future economic growth is one important challenge in the area of retail banking. The Bank will keep monitoring with strong interest what type of financial institution will play a role of intermediation through what type of channel. Concluding remarks The current financial crisis has posed various challenges to the Bank of Japan. One of them is, from a macroprudential perspective and taking into account the interconnectedness between the real economy and the financial system, to analyze and assess the risk of the financial system as a whole. The Bank of Japan has been tackling such challenge through Financial System Report and others, and intends to further enhance its efforts as well as to continue to strive to properly gauge and assess the risk inherent in the financial system. On that basis, the Bank considers that how to utilize such assessment in monetary policy or to utilize in further strengthening of financial institutions’ risk management through on-site examination, off-site monitoring, and the activities of the Center for Advanced Financial Technology, would be our next challenge. Amid changing global economic and financial conditions after the financial crisis, Japan’s economy is also faced with a difficult situation from a longer perspective. For Japan’s economy’s long-term growth, it is essential to raise the productivity of the economy as a whole. To contemplate what kind of reform in the industrial structure is required and how that can be supported on the financial system front, would also be a challenge for the Bank of Japan. By sharing wisdom with you, the Bank will make the utmost contribution as a central bank. Thank you.
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Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at a symposium commemorating the 25th anniversary of the Center for Financial Industry Information Systems, Tokyo, 13 November 2009.
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Masaaki Shirakawa: Toward development of robust payment and settlement systems Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at a symposium commemorating the 25th anniversary of the Center for Financial Industry Information Systems, Tokyo, 13 November 2009. * I. * * Introduction It is a great pleasure to have this opportunity to speak at the symposium commemorating the 25th anniversary of the Center for Financial Industry Information Systems (FISC). Since its establishment in 1984, the center has greatly contributed to strengthening the safety of financial information systems and improving the sophistication and efficiency of financial services in Japan. FISC has served the industry through its wide-ranging activities, which include developing industry guidelines on information system audit and security, publishing annual reports on financial information systems in Japan, and organizing seminars on various topics. As the center marks its quarter-century milestone, I would like to express my respect and gratitude for the work it has done over the years. The twenty-five years of FISC closely overlap with the history of the birth and evolution of the Bank of Japan Financial Network System (BOJ-NET). The Bank of Japan had just started developing the system when the center was founded in 1984. The system went live in 1988, followed by a number of improvements thereafter. These include the introduction of deliveryversus-payment (DVP) for Japanese government bonds (JGBs), the development of an outof-region backup center in Osaka, a changeover from deferred net settlement (DNS) to realtime gross settlement (RTGS), and the introduction of liquidity-saving features into the RTGS system. These measures have contributed to enhancing the safety and efficiency of payment and settlement systems in Japan. One major objective behind improvements in payment and settlement systems is to avert the negative impact of a financial crisis on the economy. As recent events in the global financial system have shown, unfortunately, financial crises occur repeatedly. While each crisis emerges in a different manner, there are certain common features: an overly optimistic outlook on the economy, followed by excessive leverage and liquidity, finally leads to a crisis; and unwinding of leverage and contraction of liquidity take place once the crisis is underway. Preventing the emergence of a bubble economy and the occurrence of a financial crisis is a challenge we must continuously tackle. However, considering the history of recurring "boomand-bust" cycles, I must emphasize the importance of building a robust financial infrastructure that can absorb shocks in a flexible manner. This is especially relevant for payment and settlement systems, which form the bedrock of the financial infrastructure. Today, I would like to present to you the Bank’s views on the challenges that need to be addressed to further strengthen the robustness of payment and settlement systems in Japan. II. Performance of Japan’s payment and settlement systems during the recent crisis The failure of Lehman Brothers in autumn 2008 triggered unprecedented disruptions in the global financial market. The aftermath of the disruptions challenged Japan’s payment and settlement systems to prove its robustness against shocks. Overall, a favorable assessment can be made that the payment and settlement systems in Japan withstood the turmoil in the financial market, operating effectively as designed. At a minimum, unfavorable issues in payment and settlement systems did not trigger a chain of defaults among Japan’s financial institutions. It is true that the financial crisis revealed some tasks that still need to be addressed. Nevertheless, I would like to emphasize that the systems have demonstrated a high level of robustness, and praise the patient efforts that the relevant parties have made to improve the systems over the years. Chart 1 shows some major streams of ceaseless efforts. In order to correctly acknowledge the progress made to date, I will start by giving two examples. A. Elimination of foreign exchange settlement risk First, the arrangement for eliminating foreign exchange settlement risk has functioned effectively. Settlement of foreign exchange transactions entails the risk, namely principal risk, that a party to a trade pays one currency, for example, the yen, but cannot receive the counter-currency, for example, the U.S. dollar – a risk that arises due to the time zone difference between the settlement systems for the two currencies. In order to resolve this problem, major banks around the world jointly invested to establish CLS Bank International (CLS; stands for continuous linked settlement) in New York, which began its settlement service in 2002. Major economies’ central banks, including the Bank of Japan, played a key role in the establishment of CLS. Under the CLS system, settlement of the two currency legs is carried out simultaneously on a payment-versus-payment (PVP) basis. Each participant holds an account for the two traded currencies at CLS, and the transfer of the two currencies is made on the two parties’ accounts simultaneously only if the payer of each currency has sufficient funds or foreigncurrency collateral for settlement in their accounts (Chart 2). Transfer of funds between CLS and its participants takes place on their accounts at the central banks, currency by currency. CLS deals with seventeen eligible currencies, and the CLS settlement process takes place during a five-hour window corresponding to the morning hours in Europe, early evening in Japan, and very early morning in the United States, respectively. CLS has played a critical role throughout the recent financial crisis. On an average day, CLS settles 3 to 4 trillion U.S. dollars, which accounts for almost 60 percent of the foreign exchange settlements worldwide. 1 While the value further surged immediately following the failure of Lehman Brothers, CLS completed settlement of the significant amounts of payments in a stable manner. The effective functioning of CLS was particularly important because, over the course of the recent global financial crisis, the functioning of the U.S. dollar funding market was severely impaired and non-U.S. financial institutions, including Japanese and European financial institutions, became increasingly dependent on foreign exchange swaps as a source of U.S. dollar funding. If CLS’s PVP mechanism had not existed and financial institutions had confronted foreign exchange settlement risk under the rapid undermining of confidence in the soundness of financial institutions, they would have had much more difficulty in funding U.S. dollars through the foreign exchange swap market. Simultaneous multi-currency settlement in CLS acted as a bulwark to protect against the intensifying shock of the global financial crisis. B. Ensuring settlement of JGB transactions A second example is that JGB transactions continued to be settled without serious problems despite the significant shock arising from the failure of Lehman Brothers Japan (LBJ). I will explain the JGB settlement process, focusing on a central counterparty (CCP) called Japan Government Bond Clearing Corporation (JGBCC). See Bank for International Settlements, Committee on Payment and Settlement Systems (2008). A CCP replaces a bilateral contract between parties with two contracts between the CCP and the individual party. Thus, the CCP becomes a buyer to every seller and a seller to every buyer. This brings two benefits. First, the CCP offsets a large number of obligations and claims across the participants, thereby reducing the amount of securities and cash needed for settlement. For example, in September 2009, an average of 35 trillion yen worth of JGB transactions was submitted to the JGBCC every day, but this came to a net 9 trillion yen or a quarter of the amount of the original transactions. 2 Second, in the event of a participant’s default, a CCP guarantees performance of delivery and payment obligations to other participants (Chart 3). In such an event, the CCP becomes unable to receive securities from the participant in default, which would result in the failure of delivery to other participants on the settlement day, the so-called "settlement fails." It would immediately attempt to purchase securities from the market and therefore resolve settlement fails. 3 For payment obligations, the CCP borrows funds to make payments to other participants as scheduled. It repays funds by liquidating the securities that were originally intended for delivery to the participant in default. A CCP cannot function well without appropriate risk management measures. A CCP needs to be equipped with contingency liquidity funding arrangements to continue the performance of payment obligations. Moreover, it needs to have adequate financial resources and losssharing arrangements among the participants, so as to be prepared for potential losses arising from the closing-out of a defaulter’s outstanding positions. JGBCC and other CCPs in Japan have been working to strengthen risk management measures. Thanks to these continuous efforts, the existing risk management controls have proved effective and the operations of CCPs have been ensured during the recent financial crisis. With LBJ’s default, JGBCC had to fund significant amounts of liquidity very quickly. Nevertheless, it managed to raise funds from external sources using the existing liquidity arrangements. In addition, while JGBCC and other CCPs suffered losses from the closingout of LBJ’s outstanding positions, those losses were fully covered by collateral that LBJ provided. 4 Having said that, there is still room for improvements in CCPs’ risk management framework. Moreover, there is also a long-standing issue with respect to JGBCC. The netting ratio of JGBCC is not high, because not all major market players participate in JGBCC. Although it is fundamentally a matter between JGBCC and the participants, a higher netting ratio would benefit all market participants. From this perspective, the Bank expects CCPs in Japan to provide the lead in efficient and safe clearing business with strengthened risk management framework. For monthly statistics of major payment and settlement systems in Japan, see the Payment and Settlement Statistics released on the Bank’s web site (http://www.boj.or.jp/en/index.htm). After LBJ’s failure, a chain of settlement fails has spread to the broad JGB markets via the CCP and other market participants who had bilateral contracts with LBJ. Since many institutional investors had little tolerance to settlement fails, market participants in general became concerned about the creditworthiness of counterparties, and the liquidity of repo market has shrunk. To address these issues, the securities industry is working to increase acceptance of settlement fails and reviewing the fails practice. See Bank of Japan, Financial Markets Department (2009b) (available only in Japanese). For the number and average duration of settlement fails, see Figures on Settlement of Japanese Government Bonds released on the Bank’s web site (http://www.boj.or.jp/en/index.htm). See Bank of Japan, Payment and Settlement Systems Department (2009a) (available only in Japanese). It explains how payment and settlement systems in Japan coped with the failure of LBJ, and summarizes the lessons learned from the experience. Also see Bank of Japan, Financial Markets Department (2009a) (available only in Japanese) and Bank of Japan (2009b). They summarize what implications LBJ’s failure had on Japan′s money markets and identify challenges for Japan’s repo markets. Apart from use of a CCP, the industry had worked on the introduction of RTGS, the achievement of DVP for securities transactions, and the dematerialization of securities certificates. Those safeguarding measures are now taken for granted, but the fact that these mechanisms prevented initial disruptions to amplify the scale of the financial crisis through malfunction of payment and settlement systems should not be underestimated (Chart 1). III. Challenges confirmed from the experience of the financial crisis As I explained, payment and settlement systems in Japan functioned well during the financial crisis. Nevertheless, there are several remaining challenges to the development of robust payment and settlement systems. The financial crisis provoked active debate on financial supervision and regulation, and opinions have not converged yet. Compared with this topic, some consensus has been reached on the way to strengthen the robustness of payment and settlement systems. What is a robust payment and settlement system? It is a payment and settlement system capable of preventing the outbreak of a financial crisis even in the face of an extremely stressful shock to itself. To realize such a robust system, it is important to identify what determines the magnitude of systemic risk, that is, the factor that influences the probability of a certain shock leading to a financial crisis. In my view, the following three measures are essential to mitigate systemic risk in payment and settlement systems: (1) reducing the size of outstanding settlement positions of individual market participants; (2) taking appropriate measures depending on the state of interconnectedness embedded in payment and settlement systems; and (3) enhancing alternative arrangements for critical settlement functions. I will explain the challenges for Japan’s payment and settlement systems, according to these three factors. A. Reducing the size of outstanding settlement positions The first challenge is to reduce the size of individual market participants’ outstanding settlement positions. While the size of financial transactions is a given with respect to a payment and settlement system, the settlement risk of financial transactions can be reduced. The key in this regard is outstanding settlement positions or outstanding exposures arising from settlement activities. Please see Chart 4. The horizontal axis shows the time from trade execution to settlement, and the vertical axis shows the settlement value of financial transactions. The longer the time to settlement, in which participants are exposed to settlement risk, the more likely one could suffer losses from the default of the counterparty. Principal risk in securities and foreign exchange settlements can be eliminated using DVP and PVP mechanisms. However, market risk – a risk of loss arising from price movements during replacement of unsettled positions – increases as time to settlement lengthens. In an intuitive sense, the area inside the rectangle in this graph shows the size of risk exposures. Given the value of financial transactions or settlement on the vertical axis, a key point for systemic risk control is how to reduce the length of time on the horizontal axis. If a time from trade execution to settlement is shortened, outstanding settlement positions will be reduced. Chart 5 shows the outstanding settlement positions where one unit trade is executed per day. In the next-day settlement system – the so-called T+1 settlement – outstanding settlement positions will be reduced to one third, compared with T+3 settlement. Moreover, if securities are delivered a day after the trading day, settlement fails, which may arise from the default of market participants, are likely to be resolved more quickly. In other words, a shorter settlement cycle contributes to reducing the risk of loss and liquidity burden arising from the replacement of unsettled positions. In the United States and the United Kingdom, the government securities markets, where huge value is exchanged every day, have moved to T+1 settlement and have managed to reduce outstanding settlement positions. In Japan, market participants have initiated a project that aims to achieve a shorter settlement cycle for the government securities market. A shorter settlement cycle not only reduces the size of outstanding settlement positions, but also makes government securities more attractive financial instruments. Government securities are highly liquid assets that are easily convertible to cash, but the securities with the T+1 settlement are more liquid and more favorable than those with the T+3. Government securities are extensively traded among a wide range of market participants including dealers, institutional investors, and foreign investors. The move to shorten the settlement cycle would require operational changes to the front, middle, and back offices of those market participants. While much work needs to be done on the market side, the Bank will provide extensive support to market participants’ efforts. B. Taking appropriate measures depending on the state of interconnectedness The second challenge is to take appropriate measures that consider the state of interconnectedness of settlement between market participants. In practice, the network of interconnections within the financial system is very complex. In a single financial market or a payment and settlement system, market participants are interconnected through trading and settlement activities. Moreover, market participants participate in multiple financial markets including money, bonds, equity, and derivatives markets, and settle their funds and securities transactions through multiple payment and settlement systems. This creates interconnectedness between payment and settlement systems by common participants. While interconnectedness raises important issues for financial supervision and regulation, I will focus on the issue of interconnectedness within payment and settlement systems. Chart 6-1 illustrates the workings of a bilateral settlement network, with market participants represented by circles and obligations between market participants indicated by lines. This is a model of one hundred market participants settling transactions in a given payment and settlement system. 5 Suppose a financial institution goes bankrupt and fails to perform settlement obligations; depending on the size of default, this could lead to subsequent defaults of its counterparties at the ends of lines. The chart does not take into account the timing of each settlement, but the order of securities deliveries and payments is also an important factor under the RTGS environment. 6 For the bilateral settlement, it is important that individual participants have adequate management of counterparty risk; for example, collection of margins and the closing-out procedures in the event of a counterparty’s default. Chart 6-2 shows an image of settlement via a CCP. As you can see, the network complexity is resolved because a bilateral contract between parties is replaced with a set of new contracts with the CCP. On the contrary, risks are concentrated on the CCP. From this perspective, and based on the experience of LBJ’s default, CCPs in Japan are reexamining their risk management, such as by reviewing contingency liquidity arrangements and strengthening stress testing schemes. It is not easy to reach a consensus among diverse See Imakubo and Soejima (2008a) (available only in Japanese). It shows that the network of bilateral obligations within financial markets has a very complex structure. It notes that the settlement network in money markets in Japan has shifted from a “hub-and-spoke” model centered on money market brokers, to a “dual structure of core and periphery” model with small-world network property, and examines what implications the changes in network structure have on systemic risk. It also gives examples of empirical studies on financial networks with respect to the money market transactions in Italy, settlement in Fedwire, and interbank exposures in Switzerland. See Imakubo and Soejima (2008b) (available only in Japanese) and Bank of Japan (2009a) (Box 2-2). They verify how liquidity shock propagates within a network through a chain of settlement delays using the real settlement data of BOJ-NET. The former demonstrates that the contagion process of liquidity shock is strongly dependent on the network structure. The latter demonstrates that the liquidity saving features of the BOJ-NET Funds Transfer System significantly reduces the magnitude of contagion triggered by liquidity shock using a simulation approach. participants in CCPs, but the Bank is confident that CCPs in Japan are making progress toward better risk management commensurate with the important roles of CCPs. Chart 6-3 shows one example of the intermediate structure. The settlement via CLS, which I explained earlier, corresponds to this structure. This network model also has a weak point. In the CLS settlement, a large number of indirect participants settle their transactions through a relatively small number of direct participants. In this business model, a direct participant takes on significant credit and liquidity risks due to indirect participants for which they settle, and this issue was highlighted during the experience of the recent financial crisis. In relation to CLS, another issue is that some important transactions are not eligible for the five-hour settlement window of CLS and are settled outside CLS. 7 To address this point, CLS is exploring the possibility of setting up a second settlement window. In sum, it is important that every payment and settlement system takes systemic risk reduction measures according to the state of interconnectedness and the network structure. As a tangent to the main point, I will give you an example of an attempt to reduce systemic risk; namely, taking advantage of a CCP for the over-the-counter (OTC) credit derivatives market, which has attracted much attention recently. In the United States and Europe, several CCPs for credit default swaps (CDSs) have been established. Traditionally, CDS contracts traded in the OTC market were settled bilaterally between market participants, as shown in Chart 6-1. The global CDS markets have expanded rapidly since the early 2000s, creating a complicated web of obligations between market participants. Major dealers’ back offices could not catch up with the expansion of CDS transactions, causing significant growth in a backlog of outstanding confirmations. As a result, it is said that regulatory authorities and market participants themselves faced difficulty understanding the size of the CDS market and the whole structure of counterparty risk that the participants were exposed to via bilateral transaction. The startup of CCPs for CDSs, as well as encouragement of the use of trade confirmation services and trade repository services, aimed to improve risk management and market transparency. Broad use of CCPs is also expected to promote standardization of OTC credit derivatives contracts. It should be noted, however, that setting up a CCP and simplifying complex relationships alone does not eliminate systemic risk. The CCP becomes the single nexus of all counterparty risks, and consequently takes on significant risks. Therefore, it must be equipped with an adequately rigorous risk management framework, and special attention needs to be paid to the continuation of clearing operations under an extreme but plausible market condition. In fact, overseas central banks have been strengthening oversight of CCPs while encouraging the use of CCPs, as they are two sides of the same coin with respect to risk concentration into a CCP. In Japan, the setting up of a CCP for OTC credit derivatives market is becoming an important issue, so I would emphasize again the importance of an adequately rigorous risk management framework. C. Enhancing alternative arrangements for critical settlement functions The third challenge is to enhance alternative arrangements in the event of disruption to critical settlement functions. Critical settlement functions could be disrupted by various kinds of contingencies including failure of a financial institution, a natural disaster, and the outbreak of a pandemic. If a certain critical settlement function is disrupted due to those external shocks and no alternatives are available, it could potentially lead to the manifestation of systemic risk; in other words, a kind of financial crisis. The same-day foreign exchange transactions are not eligible for the current settlement window of CLS. In addition, the out leg of in/out swaps – the measures used by CLS members to reduce liquidity risk in CLS settlement – is settled outside CLS. For this reason, financial institutions and operators of payment and settlement systems have been making efforts to develop and improve backup systems. Within these efforts, the strengthening of utilities services including a backup communication network and power supply has been one major challenge. Furthermore, to enhance alternative arrangements for critical settlement functions, it is important to set up contingency staffing arrangements while securing a backup for hardware and software. As we all know, FISC has been making significant contributions in this area. Thanks to these contributions, steady progress has been made in the business continuity arrangements of financial institutions and payment and settlement systems during the last decade. I hope that relevant parties will make further efforts toward the development of robust payment and settlement systems. IV. The Bank’s involvement in payment and settlement systems I would now like to turn to the involvement of the Bank in improving the safety and efficiency of payment and settlement systems. Among the various activities of the Bank in this area, today I will focus on the operation of BOJ-NET and oversight of private-sector payment and settlement systems. A. Improving the safety and efficiency of BOJ-NET I will start with the operation of BOJ-NET. As the central bank of Japan, the Bank is responsible for providing society with risk-free settlement assets in the form of banknotes and current accounts at the Bank in a safe and efficient manner. Transfer of funds across those accounts, as well as the transfer of JGBs, takes place over BOJ-NET, a settlement platform operated by the Bank. On an average day, BOJ-NET settles 50 thousand funds transfers worth 100 trillion yen and 15 thousand JGB transfers worth 80 trillion yen. BOJ-NET has continued to demonstrate extremely high operational stability and has ensured the smooth processing of such large transaction amounts. Over the years, the Bank has worked to improve the functionality of BOJ-NET. One example of recent enhancements is the Next-Generation RTGS (RTGS-XG) project for the BOJ-NET Funds Transfer System. In 2001, the system was converted from a DNS system to a pure RTGS system, which settles transactions one-by-one on a real-time basis. An RTGS system, by its design, is effective in eliminating settlement risks associated with DNS, but at the same time requires relatively larger amounts of liquidity. The RTGS-XG project aims to reduce the amount of liquidity needed under RTGS while also expanding the benefits of RTGS to largevalue payments that are currently settled in private-sector DNS systems, namely the Foreign Exchange Yen Clearing System (FXYCS) and the Zengin System (clearing system for domestic funds transfers). The project is being implemented in two phases. Phase 1 is the introduction of liquiditysaving features into the BOJ-NET Funds Transfer System and the settlement of payments in the FXYCS through RTGS. This was successfully implemented in October 2008. 8 The liquidity-saving features consist of centralized queuing and offsetting mechanisms (Chart 7). "Queuing" allows payment instructions to be held pending within the system. The "offsetting" mechanism searches among the newly entered and queued payment instructions for a set of instructions that can be settled simultaneously. Our estimate based on actual transaction data shows that the liquidity-saving features enable payments to be settled much earlier in the day using a lower amount of liquidity 9 (Chart 8). For the details of payment activity after Phase 1 and a description of liquidity-saving features, see Bank of Japan (2009a) and Bank of Japan, Payment and Settlement Systems Department (2009b). The change in average settlement time is largely due to the shift of the FXYCS from DNS to RTGS. The Bank is currently working in cooperation with the Zengin System to implement Phase 2 of the project, which aims to settle large-value payments in the Zengin System – defined as payments above 100 million yen – through RTGS (Chart 9). Implementation of Phase 2 is scheduled for November 2011 in coordination with the next upgrade of the Zengin System. With such implementation, virtually all large-value interbank payments in Japan will be processed on an RTGS basis. Another example of enhancements to BOJ-NET is the planned development of the new BOJNET system. The current BOJ-NET system went live in 1988 and has been serving the industry with highly reliable and stable operation for more than twenty years. During this period, the environment surrounding the system has gone through significant change, including increasing interconnectedness among payment and settlement infrastructure and globalization of financial markets. The Bank believes that the new BOJ-NET system should have the capability to respond to ongoing and future developments in both payment and settlement industry and technologies supporting the industry, and that this should be achieved by migrating to the latest information processing technology, adopting a system architecture with greater flexibility for future changes, and enhancing accessibility from its participants and external systems to the new BOJ-NET systems and services. The Bank decided to fully review the configuration of the BOJ-NET system, and last month released the principles guiding development of the new system and the implementation schedule. 10 This was done following a public consultation process, with many valuable opinions received from relevant parties. Some of the possible changes under the new BOJNET system include (1) expanding the range of transactions that can use the liquidity-saving features, (2) facilitating interoperability with other systems – for example, by adopting XMLbased messages – and (3) improving connectivity with other securities settlement infrastructure. The Bank believes that the enhanced BOJ-NET system will underpin the activities of financial institutions in Japan as they pursue new opportunities in response to developments in financial markets and services. The Bank will continue to closely consult with relevant parties as it develop the detailed functionalities and specifications of the new system. B. Oversight of private-sector payment and settlement systems In addition to the operation of BOJ-NET, the Bank conducts oversight of private-sector payment and settlement systems. Oversight involves monitoring the design and operation of individual systems and encouraging improvements where necessary, with primary focus placed on systems that are systemically important. Oversight is widely recognized around the world as a critical function of central banks, although its legal basis may vary from country to country. Financial stability, together with price stability, supports sound development of the national economy. Central banks have attached importance to their oversight activities to ensure that payment and settlement systems do not become a source of instability, and to lay the foundation for further enhancement of the financial system. One issue that the Bank has worked on over the years as part of its oversight activities is preparing arrangements for coping with participant default. In the international standard for systemically important payment systems prepared by central banks, it is considered best practice for multilateral netting systems to ensure completion of daily settlements on time, even in the event that the two participants with the largest settlement obligations in the system cannot fulfill their obligations. In many cases, this is achieved by using collateral, third-party guarantees, and/or contingency liquidity arrangements such as committed lines of credit. The Bank discussed the need to achieve such a high level of safety with operators of private-sector payment systems. In 2003, the Zengin System enhanced its risk management See Bank of Japan (2009c). The public consultation document is available only in Japanese. measures to meet the international best practice; the FXYCS followed in 2004. These efforts have enhanced the robustness of these systems against financial shocks. The Bank also oversees securities settlement systems. After introducing DVP for JGBs as the central securities depository (CSD) for JGBs, the Bank worked with private-sector CSDs and stock exchanges to develop detailed plans for the introduction of DVP for other types of securities; namely, dematerialized commercial paper (CP), corporate and other bonds, investment trusts, and equities. The Bank was also involved in the development of CCPs for equities and JGBs, which went live one by one from 2003 to 2005. During the planning phase of these systems, the Bank provided its views on the system design in light of international discussions and standards on risk management. As I explained earlier, work is under way to address the lessons learned from the financial crisis. The Bank has already started discussions and initiated studies with system operators and market participants on the shortening of the JGB settlement cycle and improvements in liquidity arrangements in JGBCC. Other ongoing work includes a review of market practice on settlement fails and strengthening CCPs’ risk management methodologies using stress testing. Making changes to payment and settlement systems through the oversight process takes time. The Bank considers that long-term engagement through its effective oversight activities is critical to ensuring that financial transactions continue to be settled without any friction, even in the event of a crisis. V. Closing remarks At the beginning of my speech, I touched upon some of the major developments in payment and settlement systems in Japan that have taken place over the past twenty-five years. Earlier in my career, I was involved in some of those initiatives in the late 1980s. At that time, RTGS, DVP, and dematerialization of securities seemed like a dream. After years of efforts, however, they have become reality. I am proud to have taken part in such an exciting period of Japan’s payment and settlement system development. Looking back on the past quartercentury, I would like to conclude by offering three observations. First, improvements in payment and settlement systems bring a very high return for the economy in the long run. To take a rather cynical view, over the years, financial institutions in Japan and overseas have been heavily beaten by a number of events – for example, the Latin American debt crisis, East Asian financial crisis, and the collapse of the mortgage and commercial real estate bubble – that resulted in large losses eating away at the reserves of past earnings. In contrast, investments in payment and settlement system reforms have constantly brought subtle but significant benefits to the economy and the financial system as a whole, although it is difficult to quantify such benefits at the level of individual institutions. An understanding that investments in forward-looking projects pay off can be gained simply by imagining what would have happened during the recent global financial crisis if RTGS, DVP, and various other projects were left untouched. Second, because of such wide-ranging effects, it is critical that the relevant parties continue to plan and implement changes with a long-term perspective, taking into account developments in financial markets and technological innovation. In this context, in Europe, a big project called TARGET2-Securities is under way. Under this project, participating CSDs will outsource their securities settlement function to the centralized single platform operated by the Eurosystem. This is expected to enhance efficiency and reduce costs of cross-border transfer of euro-denominated securities, contributing to further development of the integrated market. In Japan, too, continuous efforts for improvement in view of future developments will be essential. Third, effective implementation of forward-looking initiatives requires a deep understanding of and insight into the value of developing payment and settlement infrastructure, not only by working-level experts but also by the senior management of financial institutions and infrastructure providers. At many firms, payment and settlement activities are usually categorized as "back-office" functions and a "cost center." However, improvements in payment and settlement procedures could have positive externalities, resulting in advances in industry practices and market growth with new opportunities for generating additional value. I hereby ask senior management officials to review their payments business in light of such possibilities and continue to support ongoing and future initiatives in this area. I am sure that FISC will continue to play an important role in the various efforts toward development of a robust payment and settlement system. Thank you for your kind attention. References Bank for International Settlements, Committee on Payment and Settlement Systems (2008), "Progress in Reducing Foreign Exchange Settlement Risk," May 2008. Bank of Japan (2009a), "Payment and Settlement Systems Report 2007–2008," February 2009. Bank of Japan (2009b), "Financial Markets Report," March 2009. Bank of Japan (2009c), "Establishment of the New BOJ-NET," October 2009. Bank of Japan, Financial Markets Department (2009a), "Developments and Issues of Money Markets in Japan: The Tokyo Money Market Survey in August 2008 and the Impact of the Failure of Lehman Brothers," January 2009 (available only in Japanese). Bank of Japan, Financial Markets Department (2009b), "Toward the Well-Established Practice on Settlement Fails in Japan: Focusing on Significance and Role of Fails Practice and the Review of Fails Practice in the U.S., " October 2009 (available only in Japanese). Bank of Japan, Payment and Settlement Systems Department (2009a), "Lessons for Japan’s Payment and Settlement Systems Learned from the Collapse of Lehman Brothers Japan," March 2009 (available only in Japanese). Bank of Japan, Payment and Settlement Systems Department (2009b),"BOJ-NET Funds Transfers after the Implementation of Phase 1 of the Next-Generation RTGS Project," No. 09-E-04, Bank of Japan Review, July 2009. Imakubo, Kei, and Yutaka Soejima (2008a), "Transaction Network in Japanese Interbank Money Market," vol.27 (2), Kin’yu Kenkyu, November 2008 (available only in Japanese). Imakubo, Kei, and Yutaka Soejima (2008b), "The Microstructure of the Japanese Interbank Money Market: Interconnection of the Fund Transfer in BOJ-NET Settlement Data," vol.27 (2), Kin’yu Kenkyu, November 2008 (available only in Japanese). Graphs
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Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at a meeting with business leaders, Nagoya, 30 November 2009.
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Masaaki Shirakawa: Recent economic and financial developments and the conduct of monetary policy Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at a meeting with business leaders, Nagoya, 30 November 2009. * * * Introduction I am honored today to have an opportunity to speak and to exchange views with business leaders from the Chubu region. I take this opportunity to express my deep gratitude for your cooperation with the Bank of Japan’s Nagoya Branch. The last time I addressed you was in the beginning of September 2008. Immediately after that in mid-September, Lehman Brothers failed and a financial crisis broke out in the United States and Europe. Triggered by that event, the global economy deteriorated rapidly and simultaneously and economic activity in Japan deteriorated substantially, but mainly as a result of various policy measures by the governments and central banks around the world and progress in inventory adjustments, the economies both at home and abroad have started to pick up. However, the outlook remains uncertain, and many challenges remain for the global economy to shift to a sustainable growth path. Today, before exchanging views with you, I will first explain the economic developments and outlook at home and abroad as well as the thinking on the Bank of Japan’s conduct of policy. I. Developments in the global economy I will start with the global economy. While many factors were pointed out to be in the back of a sharp deterioration in the global economy since the autumn of last year, I summarize those based on the following two factors. First, the global accumulation of excesses up to the mid-2000s and balance-sheet adjustments that occurred in the process of unwinding those excesses. Up to the mid-2000s, the global economy had enjoyed, in retrospect, extremely benign conditions of high growth, low inflation rates, and low interest rates for a long period. In such an environment, the housing investment boom in the U.S. and European economies and the global increase in demand for durable consumer goods occurred. On the financial front, a rapid expansion in credit, as represented by the subprime mortgage problem, and a surge in leverage took place. While various excesses in economic and financial activities piled up during such a process, the excesses could not last for a long time. The essence of what we see now mainly in the United States and Europe is the process of solving the problems such as households’ excess debts, firms’ excess production capacity, and financial institutions’ impaired assets. That is, the process of restoring and adjusting balance sheets. During the process, economic entities will restrain spending activity and downward pressure would be persistently exerted on the global economy, especially the advanced economies. Second, the panicked financial contraction triggered by the failure of Lehman Brothers and the ensuing plunge in economic activity. The financial intermediary function deteriorated significantly around the world and the funds necessary for economic activity were not provided sufficiently, causing a rapid contraction of economic activity not only in the United States and Europe, but also in the emerging countries. Following such a severe economic downturn, the global economy started to level out around this spring, but the developments thereafter vary among the regions. The projections of the International Monetary Fund showed that the growth rate of the global economy would increase by four percentage points, to 3.1 percent in 2010 from –1.1 percent in 2009. Something striking is that the contribution of emerging economies to the growth of global economy in 2010 became larger than that of advanced economies, with the advanced economies accounting for 30 percent and emerging economies accounting for 70 percent. In the United States and Europe, while the panicked contraction of economic and financial activity settled down mainly due to the provision of ample liquidity by the central banks, public capital injections to financial institutions, and large-scale fiscal expenditure, chronic downward pressure on the economy is likely to continue in the form of balance-sheet adjustments. Therefore, although the economies are picking up, the pace of recovery is generally moderate. In emerging and commodity-exporting economies, the underlying trend of domestic demand in many of them is generally strong, reflecting the buoyant consumption associated with an improvement in the standard of living and the need for improving social infrastructure. Moreover, as emerging economies, unlike the U.S. and European economies, do not face large-scale balance-sheet adjustments, the increase in fiscal expenditure has led to high multiplier effects in stimulating domestic demand. In addition, the funds raised in advanced economies, where interest rates have remained low, have been flowing into emerging economies and has bolstered growth through, for example, an increase in bank lending and a rise in asset prices. However, the developments in those countries and regions have not been even. Careful monitoring is warranted according to the respective countries’ specific situations including the effects of the financial crisis to date, the developments in the outflow and inflow of funds between advanced economies, and conduct of macroeconomic policy. II. Current state of and outlook for Japan’s economy Based on the state of the global economy I have just mentioned, I will next explain the current state of and the outlook for Japan’s economy. After the autumn of 2008, against a backdrop of the economic downturn in the United States and Europe, Japan’s exports and production plunged, and Japan’s economy suffered an unprecedented large fall. From the spring of 2009, Japan’s exports and production have been increasing due to the progress in inventory adjustments at home and abroad as well as the effects of economic stimulus measures. Moreover, thanks to the increase in public investment and recovery in private consumption, the flash estimate of Japan’s real GDP in the July–September quarter increased by an annualized quarter-on-quarter growth rate of 4.8 percent, which was an increase for the second consecutive quarter. The increase in private demand was deemed being largely supported by various policy measures. Therefore, the Bank of Japan judges that the momentum for self-sustaining recovery in private demand remains weak while Japan’s economy is picking up. As for the outlook, the pace of improvement in Japan’s economy is likely to remain moderate until around the middle of fiscal 2010, as pressures for adjusting employment and wages are likely to remain. It is always a difficult task in terms of communication to decide what words are the most appropriate to express the current state and outlook for the economy in a short phrase. The expression I have just mentioned, “moderate improvement,” is used to also convey cautious judgments that, while the economy has gotten out of a deteriorating phase, the level of economic activity remains low and the pace of future recovery will not likely to be smooth. In fact, it cannot be denied that there is a possibility that the momentum for Japan’s economic recovery will temporarily slow at around the spring of 2010, when the effects of economic stimulus measures will wane at home and abroad. Having said that, given that the advanced economies including Japan are firmly keeping a stance to support the economy and the growth of emerging economies is robust, a possibility that the momentum for economic recovery at home and abroad will stall seems not so significant. Thereafter, in the second half of fiscal 2010 onward, it is likely that the improvements in the corporate sector originating from exports will spill over to the household sector and the growth rate of Japan’s economy will start to rise gradually. While the outlook for the global economy, which lies behind such a view, is basically similar with that of other central banks in advanced economies and not the Bank’s unique view, the Bank thoroughly recognizes that the outlook is associated with considerable uncertainty. In that regard, the Bank pays due attention to the effects of the recent rapid appreciation of the yen on business sentiment of the firms that are on the road to recovery, as well as to the effects of international financial developments since last week on the financial markets. It would be important, above all, for a central bank to examine the economy without prejudgment. Meanwhile, prices have been fluctuating substantially since 2008, like the United States and Europe, due to the effects of the changes in the prices of petroleum products. The year-onyear rate of change in the consumer price index (CPI) in Japan rose to 2.4 percent in the summer of 2008, but it became negative from the spring of 2009, and registered the largestever decline of minus 2.4 percent in August 2009. The year-on-year rate of decline in the CPI somewhat moderated to minus 2.2 percent in October, and it is expected that the pace of decline is likely to moderate to approximately minus one percent toward the beginning of next year, as the effects of the previous year’s surge in the crude oil prices abate. The question is beyond that point. While it is expected that the pace of decline will gradually moderate as the economic slack dissipates, it is likely that downward pressure on prices will remain for an extended period reflecting a moderate improvement in the economy. Therefore, in the Outlook for Economic Activity and Prices issued at the end of October, the Bank released a grim outlook that the price decline will likely continue until fiscal 2011, albeit the pace of decline gradually moderating. While the Government expressed recently its view that the Japanese economy was in a mild deflationary phase in that the decline in prices was continuing, the Bank’s judgment on prices presented at the end of October is based on the same recognition with such Government’s view. III. Conduct of monetary policy Based on the recent economic and financial developments, let me explain next the Bank’s monetary policy management. In terms of monetary easing, the Bank had reduced the policy interest rate to 0.1 percent toward the end of 2008, in order to steadily support economic activity on the interest rate front. As a result, short-term interest rates in Japan are now at the lowest levels in the world. While those low interest rates have power to support economic activity of firms and households, the potential economic stimulus effects of low interest rates tend to increase as the economic environment improves. In October this year, the Bank expressed again its aim to maintain the extremely accommodative financial environment and provide steady support for Japan’s economy, and I will emphasize again today that the Bank firmly maintains such a stance. The Bank will thoroughly check the future developments in the economy and prices and take appropriate policy responses to bring Japan’s economy back to a sustainable growth path with price stability. In terms of the effects of monetary easing, it is important to ensure the stability of financial markets. To ensure the stability of the financial markets is a responsibility as a central bank, and I will reemphasize that the Bank is always prepared to act promptly and decisively if judged necessary to ensure the stability of financial markets. IV. Responses to deflation In relation to the policy management, I will now describe the basic thinking on coping with the issue of deflation. As previously mentioned, the Bank has been doing its utmost as a central bank to meet the challenge of getting out of the state of continued decline of prices, namely, deflation, and put Japan’s economy back to a sustainable growth path with price stability, and made it clear to continue with such stance. To begin with, at the root of a continued decline in prices, there is a fundamental factor that demand is weak compared with the supply capacity of the economy as a whole. The starting point of the current price decline was the rapid contraction of financial and economic activities since the autumn of last year, and, as a result, the supply and demand balance deteriorated significantly. In order to deal with such situation, it is necessary to prepare an environment conducive to a sustainable expansion of final demand, such as business fixed investment and private consumption. In other words, on a policy front, it becomes critical to make households feel secure about their future and firms able to have expectations about the future growth. At the same time, as long as there will be no recurrence of the excessive booms in the United States and Europe, it will be essential also for firms to convert their supply system into a new one that is in line with consumers’ needs in a new era. As such, steady efforts on the part of the policy authorities as well as the private economic entities are necessary for coping with the issue of deflation, and such a process necessarily takes some time. In the meantime, it is also important to avoid a situation in which the decline in prices induces adverse effects on economic activity, which in turn leads to a further decline in prices, namely, a vicious circle between economic activity and prices. History shows that most of the cases, in which a decline in prices induced contraction of economic activity and resulted in a vicious circle between economic activity and prices, took place during the period when the financial system became extremely instable through bank failures and others, namely, during the period of financial contraction. In such a situation, firms that faced funding difficulties made fire-sales of their own products to meet day-to-day funding needs or could not maintain employment. That in turn led to a decline in prices and wages, resulting in further deterioration of the economy. While that might be an extreme case, a valuable lesson in history is that it is critical to ensure the stability of the financial system in preventing a vicious circle between the economy and prices. As described, in coping with deflation, what becomes a key is first, to keep improving the supply and demand balance of the economy as a whole, and second, to prevent a vicious circle between economic activity and prices, especially to maintain the stability of the financial system. Based on such thinking, the Bank will do its utmost to overcome deflation both in terms of monetary easing and ensuring the stability of the financial markets. V. Toward sustainable growth I have been explaining the thinking on policy responses to deflation. Given that the essence of the issue is the deterioration in the supply and demand balance of the economy as a whole, efforts to overcome deflation overlap the efforts to strengthen the potential of Japan’s economy, namely, to strengthen the growth potential itself. To that end, I will next touch on the challenges toward a sustainable growth of Japan’s economy. Sustainable growth of the economy is achieved through a sustained expansion in final demand, and an associated expansion in the supply capacity. In the economic analysis, economic growth viewed from the supply side is often analyzed by looking into three factors, namely, growth in capital stock, growth in labor force, and growth in productivity. This is a method referred to as growth accounting. By using the method, I will review the source of growth during the period when Japan’s economy was growing at a much higher rate than now. Typical study in this regard is the analysis by Professor Masahiro Kuroda, the former President of the Economic and Social Research Institute, Cabinet Office. According to the analysis, in the 25 years between 1960 and 1985, Japan’s annual growth rate was 6.8 percent on average, of which growth in capital stock, labor force, and productivity accounted for 3.7 percent, 0.9 percent, and 2.2 percent, respectively. While both expansions in demand and in supply capacity are of course necessary for achieving a sustainable economic growth, in meeting such expansion from the supply side, growth in labor force accounts for a surprisingly small degree, and an increase in capital stock and a rise in productivity are significant. In that regard, the efforts to tackle the population decline and the associated problems are without doubt important, and, similarly, we are left with two key factors. First, where to expect a source of demand expansion. And second, how to achieve a rise in productivity. First, in terms of source of demand expansion, significant challenges are to foster households’ confidence about their future and prepare infrastructure conducive to expansion of domestic demand, as well as, given a future decline in population, how to take in the expanding demand of emerging and commodity-exporting economies. Having said that, I am not insisting that Japan should increase its dependence on merchandise exports to emerging economies. Various ways can be considered to take in demand. In fact, in the past five years, the factors that account for Japan’s current account surplus have been changing, and more than 70 percent of Japan’s current account surplus now comes from the receipt of income from abroad associated with securities and direct investments. The important point is, in addition to merchandise exports, the efforts to strengthen the relationship with emerging economies in various forms, including vertical and horizontal specialization, are required. The efforts to raise productivity from the supply side are also critical. Corporate managers have been working on the establishment of global production bases and the development of high-value-added products meeting the needs of consumers. Such moves will lead to exploring new demand. As is the case with the changes in demographic composition, new demand will surely be created as long as the economy and society consistently change. The challenge for firms is to make potential needs into actual demand. While the output gap has been often discussed in economic debates, the discussions have been done by comparing demand for products based on the existing needs with the supplying capacity of products that meet such needs. Given that the unprecedented global bubble has burst, it cannot be expected that demand will be created to meet the supplying capacity of the same products in the past. In that context, the oft-discussed output gap seems to have an aspect of an indicator of the mismatch between supply and demand. What is important is the corporate effort to make potential needs into actual demand. In addition, to support such firms’ efforts, the systems or mechanisms should be reviewed so as to ensure the flexibility of Japan’s economic structure according to the changes in society and in the global economy. For example, the rate of establishment of new firms and the rate of closure of the existing firms in Japan are less than half of those in the United States, suggesting that the metabolism of Japan’s economy is low. While consideration from various angles would be necessary in order to improve such a situation and prepare a mechanism through which production resources transfer smoothly to areas with strong needs, from the standpoint of a central bank, I will emphasize the role of financial markets, financial institutions, and institutional investors. The financial markets facilitate an efficient fund allocation according to profitability and potential of firms as well as risks, thereby play a role in enhancing the metabolism of the economy. In that regard, a more efficient fund allocation will be possible if versatile markets exist and various fund providers assess the profitability of firms and others. Therefore, to develop versatile and efficient financial markets is likely to play an important role also in raising the productivity of the economy as a whole. Concluding remarks Needless to say, economic growth is eventually achieved by the power of human will. In that regard, in Nagoya, there are many firms that have taken various changes in the environment as new opportunities and have achieved high growth by responding to the changes. Recently, there have been moves to develop and expand the production of high-value-added products including energy saving automobiles, which is reassuring. If such efforts are stepped up, it would pave the way to a sustained growth path for Japan’s economy. The Bank will do its utmost to support your such efforts from the standpoint of a central bank. Thank you.
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Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Central Bank of Malaysia - Bank for International Settlements' High Level Seminar, Kuala Lumpur, 11 December 2009.
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Masaaki Shirakawa: Reforming the framework of financial regulation and supervision – an international and Asian perspective Speech by Mr Masaaki Shirakawa, Governor of the Bank of Japan, at the Central Bank of Malaysia – Bank for International Settlements’ High Level Seminar, Kuala Lumpur, 11 December 2009. * 1. * * Introduction I am very much honored to have this opportunity to speak before such distinguished participants, including those from central banks, at this High Level Seminar co-organized by Bank Negara Malaysia and the Bank for International Settlements. Today, I would like to offer my reflections on the lessons from the current global financial crisis. However, under this theme, many issues have already been raised and numerous discussions held. I myself have participated in many such discussions at many international forums and, I have to confess, I have been wondering about some piece missing in these discussions. Thinking about why this has been the case, I came to realize one of the reasons I feel this way is that such discussions have been mostly conducted under the designation of “global financial crisis”, despite the fact that Asian financial systems, including that of Japan, have remained relatively stable. Sufficient consideration has not been extended to such aspects as regional diversity and differences in the structures of financial intermediation. In this regard, I would like to express my views on the lessons of the global financial crisis, from both an international and an Asian perspective, as the financial structure in Asia differs from those in the United States and Europe. I will first present some ideas as to why financial systems in the Asian region remained relatively stable under the current crisis, compared with those in the United States and Europe. Then, I would like to talk about how we should make use of the lessons we have learned from the current crisis, from such a perspective 1. 2. Relative stability of financial systems in the Asian region during the current crisis To begin with, let us consider how we should assess the performance of the financial systems in the Asian region during the current crisis. A fair assessment, in my own view, would be as follows. First, Asian financial systems obviously could not be immune to the global financial turmoil, and have indeed been seriously impacted. Second, compared with what happened in the United States and Europe, financial systems in Asia remained relatively robust, and here I need to stress the word “relatively”. For example, between the collapse of the Lehman Brothers in September last year and early 2009, the share price of Asian financial institutions plummeted by 30 to 40 percent, depending on jurisdiction. In most Asian economies, the prices have now recovered to preLehman levels, and in some economies have even exceeded that level by more than 30 percent. The performance of financial shares matches that of average indices covering all sectors. On the other hand, the rebound in the U.S. and European banking sectors is clearly See Masaaki Shirakawa, “Preventing the Next Crisis: The Nexus between Financial Markets, Financial Institutions and Central Banks”, speech at the London Stock Exchange (May 2009), and “International Policy Response to Financial Crisis”, remarks at the Symposium Sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming (August 2009), for discussions on reforming the framework of financial regulation and supervision based on the lessons from the current financial crisis. weaker, recovering only to 70 to 80 percent of pre-Lehman levels, while indices of all sectors have recovered to roughly 90 percent. The difference of performances between Asian and U.S./European financial institutions is also reflected in their respective balance sheets. While the ratio of non-performing loans has recently shown a steep rise in the United States and Europe, it remains stable at a low level here in Asia. Bank lending growth has decelerated sharply in the United States and Europe and recently turned negative in some countries. In most Asian jurisdictions, it has also decelerated in recent periods but remained positive, and even accelerated in China. Likewise, Japan’s financial system has enjoyed relative robustness compared with the U.S. and European systems. Libor-OIS spread 2, which directly reflects the stress in a funding market, widened in the aftermath of the Lehman shock until the end of last year, as it did in the United States and Europe. However, in yen funding market, the spread remained relatively narrow, and is currently back to August 2007 levels. Third, the impact of the current crisis in the Asian region has been smaller than that of the Asian financial crisis of 1997 to 1998. The Asian financial crisis led to sovereign debt crises, and some economies were compelled to seek financial support from the International Monetary Fund. The situation this time is not nearly as serious. 3. Backgrounds to the robustness of Asian financial system This begs the question: How could Asian financial systems remain relatively robust this time? In my view, the main reason is that the memory of the previous severe financial crisis was still fresh in our minds, and the lessons learned from that crisis were put to good use, even if not perfectly. There were a variety of factors behind the Asian financial crisis, and they were combined with each other in a complex way. The key factor that directly precipitated the crisis was the double mismatch of currency and maturity formation in the asset and liability structures of financial institutions, creating a downward feedback loop between currency risk and liquidity risk. With this bitter experience in mind, many Asian economies endeavored to increase the robustness of their financial systems. First, financial institutions themselves took measures to improve risk management. Mismatches were reduced, although further effort seems necessary. Moreover, most Asian financial institutions adopted a cautious approach towards the complex securitization products in their investment decisions, as memories of the Asian financial crisis were still fresh in their minds. This led to the comparatively lower credit costs this time. Second, the Asian regulatory and supervisory authorities made efforts to enhance the resilience of their financial systems. They used a variety of measures to enhance the robustness as well as the transparency of the financial systems, including attracting foreign capital and facilitating mergers. Moreover, with the enactment of laws and regulations concerning deposit insurance and prompt corrective action, the financial systems were provided with safety-nets to ensure stability in times of crisis. Third, following on from the previous point, liquidity backstops were put in place in preparation for turmoil in the financial and foreign exchange markets. Central banks have been equipped with market operation tools and standing facilities to ensure liquidity in domestic funding markets. A regional network of currency swap arrangements was expanded under the Chiang Mai initiatives to ensure liquidity in foreign currency markets. Libor-OIS spread is the difference between the Libor and the overnight index swap rate, which could be considered as an indicator of counterparty credit risk and liquidity premium. Enhanced foreign reserves, flexible foreign exchange mechanisms, and stringent fiscal discipline also contributed to reducing concerns over sovereign risk. 4. Learning from past crisis experience And yet, even if we learn all the lessons past crises have to teach us, can we guarantee the resilience of the Asian financial system in the future as well? I must say, I refrain myself from being optimistic in this respect. I have my doubts because, first, it is difficult for any of us to truly learn from the experience of others. Since the bursting of the bubble and the subsequent financial crisis in Japan, there has been much discussion of the so-called “lost decade” by academics and policymakers abroad. However, I must say that the implications of our experience, such as the severity of liquidity crisis and balance sheet adjustments, have not been fully taken to heart 3. Even if the lessons of a crisis are correctly understood by outside observers, it is often difficult for those to implement necessary measures in their jurisdictions without actually experiencing a crisis. For instance, it was only by facing so many failed financial institutions after the bursting of the bubble that Japan learned the importance of an infrastructure whereby failed institutions can be resolved in an orderly manner. We had to overcome so many difficulties before we finally introduced the resolution regimes we are equipped with today. After the outbreak of the current financial crisis, I was rather surprised to learn that resolution regimes were not yet fully introduced in many European countries. Thus, I realized again how difficult it is to learn from the experience of others and to translate that into one’s own action. The financial systems in Asian economies were relatively stable during the current crisis, but we need to recognize that by feeling less pain, we in the Asian region may have missed something that we were supposed to learn during this new experience. Second, memories fade with time and as generations pass. I mentioned earlier that Asian financial institutions, including Japan’s, were cautious in investing in complex securitization products, but there is no guarantee that they will remain prudent in the future. History provides us with so many examples of one success leading to complacency: the bubble economy of Japan in the late 1980s, the East Asian Miracle of the early 1990s, and the Great Moderation of the mid-2000s, to name just a few. Third, since crises emerge in different guises depending on the stage of development and the structure of the economy, the way we respond to a crisis should also evolve. In order to maintain financial stability, the mechanism of financial institutions’ governance and the safety-net of the economy, or indeed of society in general, are of crucial importance. However, there is no governance mechanism or safety-net arrangement that is appropriate for all societies at all times. The Asian crisis taught us the downside of free capital flows if a country is not equipped with the appropriate bank supervision and regulation. In the arguments over the so-called crony capitalism, the Asian financial system was once criticized for its opacity, which was considered to be the result of favoritism based on family and local ties. It is beyond my ability to judge whether such criticism was justified or not, but it is quite possible that at some stage of economic and social development, factors, such as long-term customer relationships and mutual assistance, do have a role to play in the governance mechanism. The exact form of governance mechanism still varies across societies even in the age of globalization. In reviewing policies and systems, including financial regulation and supervision, it is very important that each jurisdiction strives to find an answer that best fits its own financial and economic structures. See Masaaki Shirakawa, “Way Out of Economic and Financial Crisis: Lessons and Policy Actions”, speech at Japan Society in New York (April 2009) for discussion on the so-called “lost decade”. 5. Towards better financial regulation and supervision Vigorous discussions are currently being held in a variety of international forums, including the Financial Stability Board and the Basel Committee, with a view to reforming the framework of financial regulation and supervision. Although the Asian financial system remains relatively stable, it cannot be guaranteed immunity from global financial crises, and has actually been significantly impacted by the current crisis. A robust global financial system is a public good that benefits the whole world. This cannot be over-emphasized. In order to prevent another financial crisis, each country should be well aware of this common objective in the first place. Efforts should then be made to organize an internationally consistent regulatory and supervisory framework. In making such efforts, we must be very cautious that the reforming of the financial regulatory and supervisory framework is conducted in a well-balanced manner. When we talk about regulation and supervision, we should not confine the discussion within the sphere of regulation and supervision itself. We should rather keep our eyes on its wider context. When we embark on regulatory and supervisory reform, I believe, it is very important to strike the right balance in a number of dimensions as follows. Balance between macroeconomic policy and financial regulation and supervision First, balance is needed between macroeconomic policy, particularly monetary policy on the one hand, and financial regulation and supervision on the other. In recent years, there has been a growing tendency among academics and central bankers to draw a clear line between the role of monetary policy and that of supervision and regulation: namely, monetary policy should aim at price stability, and regulation and supervision should aim at financial system stability. However, what we actually witnessed during the credit booming period was an unwelcome combination of asset prices increase, rapid credit expansion, and subdued inflation. As a result, debate has been often framed in terms of a trade-off between price stability and financial system stability. However, the true trade-off is not between price stability and financial system stability, but it exists intertemporally between economic stability of the present and that in the future. Although ensuring the soundness of individual financial institutions through regulation and supervision is surely important, the sound management efforts at a micro level may not be sufficient to guarantee the financial system stability. From a macro-perspective, however, if we maintain a monetary policy that accommodates excessive leverage and maturity mismatches over the longer term, someone will eventually take excessive risk, and this will lead to an erosion of financial system stability. That is why monetary policy, too, should be conducted with a macro-prudential perspective, aiming at sustainable price stability in the longer term. At the same time, we must avoid strengthening regulatory framework becomes an impediment to macroeconomic stability. In this sense, we must carefully assess the condition of global economy to determine the timing for implementing the strengthened capital standards. For this, as declared in the Statement of the G20 Pittsburgh Summit in September, it is necessary for us to take an approach that strengthening of the capital standards should be implemented as economic recovery is assured. Balance between regulation and self-discipline Second, balance is needed between regulation applied to financial institutions on the one hand, and management and self-discipline by financial institutions themselves on the other. Financial markets are ever-changing and business models differ across institutions. Given the limited resources of supervisors and regulators, it is impossible to supervise or regulate every inch of the activities of financial institutions. Moreover, given the limited liability of shareholders, the myopic behavior of shareholders and managers cannot be restrained simply by enhancing minimum capital ratio standards or through other regulations. Before the emergence of the subprime loan problem, most financial institutions were well-capitalized in terms of the regulatory definition of capital. Of course, we can say this is owing to the deficiency of the current capital regulation. That is, risks are not adequately captured in the calculation of the capital ratios. At the same time, however, this seems to suggest how intrinsically difficult it is to capture risk correctly in a timely manner. After all, the first line of defense of a financial institution is its managers whose task is to properly identify and manage risks to ensure the financial soundness of their institutions. On a related issue, the mechanism and factors that govern the self-discipline exercised by managers varies from country to country. A typical example is the compensation scheme for managers. If you check the disclosure journals of U.S. and Japanese financial institutions, you will notice a huge difference between the two countries in terms of the level of compensation for managers. In its recent report, the Financial Stability Board describes a number of attributes required of a desirable scheme and level of compensation. For my part, I would just like to emphasize that managers’ appropriate judgment on strategic issues is crucially important. Balance between regulation and supervision Third, balance is needed between regulation and supervision. There is a non-negligible difference among countries in terms of financial and economic structures, as well as in terms of the business models of financial institutions. A minimum set of common rules is needed to be applied to internationally active financial institutions. At the same time, however, it is also important to leave a certain amount of room for local regulators and supervisors to adapt to the local situation. For example, the appropriate method of liquidity management can differ according to the business model of a particular financial institution. When considering liquidity regulation, the first item that comes to many people’s mind as qualified liquid assets would be government bonds. However, in some Asian jurisdictions, outstanding amounts of government bonds issued are small, as a result of fiscal discipline. For such jurisdictions, a uniform liquidity regulation could even be harmful. In Japan, supervisory authorities are monitoring the liquidity positions of financial institutions in a more detailed manner on a routine basis. Thus, at the time of the Lehman shock, the Bank of Japan was in a position to know on a daily basis the funding activities of financial institutions, including foreign banks and securities firms. This type of information was particularly valuable when the Bank of Japan conducted open market operations in such a stressed situation. This is one of the reasons why Japan’s financial system was able to remain relatively stable at that time. Of course, not all countries can afford to conduct such monitoring on a regular basis. Thus, the best way of addressing these issues may be more or less different across jurisdictions, and it might be difficult to always establish an internationally uniform hard-wired standard. As I mentioned earlier, I strongly believe in the necessity of internationally common rules. That said, it is hard to draw a clear line between those areas where internationally common rules should be applied, and those where domestic rules should be applied. The same holds for determining whether supervision or regulation should play the main role in a particular area. I would like to emphasize the importance of both; that is, internationally common rules on the one hand, and due respect for the differences among countries and institutions on the other. Balance between preventing crisis and containing ripple effects Fourth, balance is needed between policies aimed at preventing crisis and those aimed at containing the ripple effects of a crisis that has already occurred. Even if all the efforts I have mentioned were made, including macroeconomic policies, regulation, supervision, and selfdiscipline, there will always remain the possibility of financial institution failure. Recognizing this harsh reality, we have to redouble our efforts to construct a financial infrastructure that is resilient to shocks. Challenges abound in this sphere, but I would like to stress the crucial role of the smooth transfer of liquidity across currencies, time zones, and jurisdictional boundaries. It is the lack of liquidity, rather than the lack of capital, that directly causes failures of financial institutions. Therefore, we should endeavor to prevent the crisis contagion triggered by concerns over a lack of liquidity. In this regard, for example, currency swap arrangements and cross-border collateral arrangements could both be effective liquidity supplement tools. Enhancing the infrastructure of financial transactions, including the shortening of settlement periods, is also an important issue. 6. Concluding remarks As I have argued, striking the right balance in a variety of dimensions is important for realizing financial system stability. I would like to conclude my remarks with a few words mentioning that in order to attain the kinds of balance I have outlined, it is crucial for the relevant organizations and personnel themselves to have a balanced and broad perspective on the issues at hand. The Japanese financial crisis was a result of the bursting of the bubble that emerged in the late 1980s. During this bubble era, I was working in the monetary policy area. For several years after the bursting of the bubble, I was involved in the resolution of failing financial institutions and in developing the necessary framework to carry out such resolutions. In the late 1990s, I moved over to work on international financial markets, and in the several years just before and after the Asian financial crisis, I was involved in the work carried out by the Committee on Global Financial Systems hosted by the Bank for International Settlements. After that, I returned to the monetary policy area until the mid-2000s, covering a period identified with a number of keywords, including the bursting of the IT bubble, deflation, and the Yen carry trade. Looking back, I believe the knowledge and intuition that I gained through this experience has been extremely valuable in making policy decisions in the face of the recent crisis. Such personal experience has led me to emphasize the importance for people involved in the world of financial stability to have as broad a perspective as possible, rather than confining themselves in a silo, and for staff to experience a variety of jobs in rotation. It is also quite important for the management of central banks and regulators to foster such an institutional culture. International human networks are also a vital element in developing a broader perspective. The recent crisis has reminded us of the significance of international networks and cooperation. From such a viewpoint, I would like to express my gratitude once again to Bank Negara Malaysia and the Bank for International Settlements for organizing this fruitful event, which has made a most valuable contribution to widening our perspectives. Thank you very much for your attention.
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