Economic Survey of Japan 2005: Ending deflation and achieving a self-sustained expansion

 

Is the economic expansion likely to continue?

The expansion is projected to continue through the end of 2006, though at a more moderate pace of around 1½ per cent. The upturn has been led by business investment, reflecting the progress made in restructuring and rising profits from strong exports. China has played an important role, accounting for a third of the increase in Japanese exports during the past two years. Although the pace of business investment and export growth may slow, employment gains are likely to support private consumption. Such an outcome would help make this the longest upturn since the 1980s and may bring an end to seven years of deflation, as measured by the consumer price index. However, the expansion paused in the second and third quarters and there are risks, both domestic and external, to a sustained expansion. On the domestic side, the strains related to the rising public debt and the risk of a marked increase in interest rates are most important, while a continued decline in nominal wages would weaken private consumption. On the external side, a slowdown in world trade in the context of rising oil prices, or a sharp appreciation of the yen could also weaken growth. All of these factors make the current outlook more uncertain.

What is the appropriate strategy for monetary policy?

In this uncertain context, the Bank of Japan should remain focused on ending deflation and its negative implications for economic growth. The quantitative easing policy has boosted the monetary base by 60 per cent over the past three years, preventing financial instability and keeping long-term interest rates low. The stability of the effective exchange rate during the first three quarters of 2004, despite no further intervention in the foreign exchange market since March 2004, has helped to keep monetary conditions relaxed. The Bank of Japan promised in 2003 to continue the quantitative easing policy at least until core consumer price inflation (excluding fresh food, but including energy) is zero or above and the Bank's Monetary Policy Board projects it to be positive during the forecast period. The latter condition was partially fulfilled when the Board projected core inflation at 0.1 per cent in FY 2005, although it expects it to remain negative at -0.2 per cent in FY 2004.

The success of the exit from the quantitative easing strategy depends in part on its timing. The stated conditions for changing monetary policy noted above leave open the possibility that an end to quantitative easing could occur when inflation is only marginally above zero. However, an early tightening of monetary policy could push Japan back into deflation. The Bank of Japan should thus raise the threshold for ending quantitative easing to a level that is sufficiently high - such as 1 per cent - to make the risk of renewed deflation negligible. On the other hand, maintaining the current monetary policy for too long may lead to high and sustained inflation, given the large expansion of the monetary base since 2001. On balance, though, the cost of overshooting the optimal level of inflation is less than remaining mired in deflation.

Setting a higher inflation threshold as a condition for changing monetary policy would also help to guide private-sector expectations and prevent a large reaction in markets that could occur even before policy changes. The quantitative easing policy is implemented through central bank purchases of securities such as government bonds, commercial paper, bank bills and asset-backed securities. The Bank of Japan's purchases of government bonds have attracted private-sector investors to this market and resulted in a large run-up in bond prices. Once the current monetary policy comes to an end, there is a risk that long-term interest rates will increase substantially, leading to significant losses for financial institutions. Such a risk could be kept to a minimum by a clear communication strategy that provided as precise information as possible to the markets on how the exit strategy from quantitative easing would be conducted. At a minimum, a higher inflation threshold for ending quantitative easing as recommended above would delay the normalisation of interest rates, thus allowing banks more time to strengthen their balance sheets and increasing the scope for offsetting capital gains in other assets, including land and equities.

What should be done to further strengthen the banking sector?

There has been progress in rehabilitating the banking sector, which is necessary for an effective monetary policy and a sustained recovery, given Japan's bank-centred financial system. The major banks, which have reduced their stock of non-performing loans (NPLs) from 8.4 per cent of their total lending in March 2002 to 4.7 per cent in September 2004, are on track to achieve the government's goal of reducing the ratio to about half of the March 2002 level by March 2005. At the same time, the banking sector has returned to operating profitability for the first time in a decade. However, the core profitability of banks remains low and there remains concern about the strength of their capital, given that "deferred tax assets" account for a third of the major banks' Tier I Capital and are conditional on future profitability. This may be contributing to a decline in bank lending, adjusted for write-offs of NPLs, which has fallen for seven straight years. The supervisory authorities should maintain the pressure on the banking sector to cut NPLs and strengthen capital.

Compared to the major banks, less progress has been achieved in restructuring the regional banks. Government policies towards these banks are driven, in part, by concerns about financing for small and medium-sized enterprises (SMEs). The authorities are monitoring plans submitted by 626 financial institutions in 2003 to revitalise SMEs and it recently bailed out a bankrupt regional bank in an effort to limit systemic risk in the region. These policies have contributed to a rising trend in regional bank lending, although this is due in part to their loans for housing, which are replacing declining public lending. However, pressuring banks to achieve targets for lending to SMEs may conflict with the banks' primary responsibility to their shareholders and may result in significant fiscal costs in the future. To avoid such problems, the guidelines for lending to SMEs should be removed. The authorities should also establish specific measures for reducing NPLs, similar to those for major banks, and use caution in implementing the new scheme for public fund injections into regional banks to avoid moral hazard problems and large budgetary costs.

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