Home > About the Bank > Speeches and Statements > Speeches 1996–2010 > Speeches 2004 > Recent Economic and Financial Developments
Recent Economic and Financial Developments
Summary of a speech given by Toshikatsu Fukuma, Member of the Policy Board, at a meeting with business leaders in Nagasaki on March 25, 2004
April 30, 2004
Bank of Japan
Contents
- I. Economic Conditions at Home and Abroad: Current State and Future Outlook
- II. Quantitative Easing Policy of the Bank
- III. The Future of Banking Business
- Concluding Remarks
I. Economic Conditions at Home and Abroad: Current State and Future Outlook
A. Developments in the World Economy
1. Recent economic and price conditions
There are three particular aspects of current conditions in overseas economies that I would like to draw attention to. First, as shown in Chart 1, the world economy is on a recovery trend, and, what is more, the recovery is spreading to emerging countries such as Brazil, Russia, and India. The high growth potential of these three countries and China has attracted the world's attention to such an extent that they are often grouped together as the BRIC economies. According to projections by a major foreign securities house, in less than 40 years, the combined GDP of the BRIC economies will surpass that of the G6 economies. Second, Asian economies led by China in particular have continued to register faster economic growth, and, as Chart 2 shows, their shares of global GDP and international trade have risen sharply. This notable performance can be attributed to an expansion in these countries' domestic demand due in part to their easy monetary policies, leading to increased trade among the countries in the region including Japan-in other words, an autonomous growth mechanism is functioning. Chart 3 shows the rise in intra-regional trade, especially in exports destined for China. And third, inflation has remained low despite the global economic recovery, as shown in Chart 4-1. Two factors contributed to this phenomenon. First, economic globalization has brought about a sharp increase in the supply of low-priced, quality products from emerging countries including the BRICs and Asian nations, making it harder for more advanced industrial countries to maintain control of the prices of competing products. And second, there has been a rise in productivity, as shown by the decline in the unit labor cost in both the United States and Japan (see Chart 5). Competitive firms have achieved higher productivity by means of restructuring, business process reengineering (BPR) through IT, and outsourcing, i.e., utilizing high-quality, low-cost labor overseas. It must be noted, however, that the expansion of China's domestic demand and its growing position as "the factory of the world" have entailed a surge in prices of raw materials such as iron ore, scrap iron, copper ore, oil, and coal, as well as shipping freight rates, as Chart 6 illustrates. Chart 4-2, however, shows that in the United States the surge in crude goods prices has yet to affect finished goods prices. It is necessary, therefore, to monitor closely the possible effect of the rise in upstream prices on final product prices, corporate profits, wages and the employment situation, that is to say its effect on general economic trends.
2. Risk factors affecting the world economy
There are a number of risk factors posing a threat to the current steady global economic recovery: developments in the currency market, possible large-scale terrorist attacks, a further spreading of the bird flu epidemic; and in addition, economic developments in China and the United States which also need careful monitoring. Although China is still enjoying robust economic growth, some potential bottlenecks have started to emerge, in the shape of electricity and water shortages, as well as traffic congestion. Recently, the National People's Congress set the nation's economic growth target for 2004 at 7 percent, lower than the actual 9.1 percent expansion in 2003. Furthermore, the central government decided to introduce measures to prevent duplicative investment by local governments. The country's economic expansion could therefore slow to some extent, although the rate of growth is liable to remain relatively high.
As for the U.S. economy, fiscal expansion, namely tax cuts, and monetary easing have helped the economy to recover steadily with business fixed investment and private consumption remaining firm. Whether the recovery will remain on track, however, depends on prospects for the job market and the direction of gasoline prices, which have recently been rising sharply. The employment situation in the United States has been affected by efforts to improve productivity. Compared with Japan and other countries, the conspicuous feature of productivity improvements in United States is that they have been brought about by exhaustive implementation of BPR using IT and by extensive outsourcing of jobs overseas. To quote some examples, outsourcing has not been confined to the transfer of factories to China; there have been cases of businesses consigning service sectors such as bank back-office operations or airplane designing, as well as software development, to countries like India, Russia, and the Philippines. The phrase "jobless recovery" was coined to describe recoveries such as the current one, which has been accompanied by little in the way of new job creation. This is a fact for which vigorous outsourcing overseas is blamed at least in part. This phenomenon should be kept in mind as an object lesson when considering solutions to the challenges facing the Japanese economy.
B. Developments in the Japanese Economy
1. Current conditions
In Japan, a positive cyclical mechanism is at work, based on sharp increases in exports mainly to Asian countries boosting production and triggering a rise in business fixed investment. Among the exports driving these increases, high levels of growth have been seen in sales of machinery and equipment accompanying direct investment into China, as well as in exports of machine parts for existing local factories. Exports of cement, construction machinery and steel products to Asian countries including China are also brisk thanks to active infrastructure construction in the region.
With regard to capital expenditure in Japan, investment to raise production capacity for plasma display panels, liquid crystal displays, charge-coupled devices (CCDs) and other cutting-edge electronic components, has increased substantially reflecting an increase in demand for the so-called "three new household treasures" (digital cameras, flat-screen televisions, and DVD recorders). In addition, an increasing number of firms in the materials and machinery industries are refurbishing facilities or building new factories. Business fixed investment at a wider range of small and medium-sized firms is also showing signs of some strength as the benefits of brisk business among larger firms filter through to them. These developments are taking place alongside scrapping of redundant facilities due to mergers and tie-ups and also ahead of the planned introduction of impairment accounting, helping to reduce excess capacity.
Private consumption is also continuing to improve. People are drawing upon their savings, and consumer sentiment is brighter, reflecting increases in both the number of employees and overtime payments as well as a wealth effect from higher stock prices. It is against this background that the sales of digital home electronic appliances, foodstuff, and clothes have been buoyant. There are therefore signs of recovery in both internal and external demand, and a phase of autonomous recovery seems almost in sight.
2. Business results
As Chart 7 makes evident, there is no doubt that the business results of manufacturers such as automobile and electrical machinery makers will be favorable for the current fiscal year, ending March 31. Satisfactory performance is also wide-spread among non-manufacturers, with a number of firms in the communications, transportation, real estate, electric utility, and financial sectors forecasting record high profits. Regardless of sector, business scale, or region, business results are recovering in a wide range of firms that have been rigorous in pursuing rationalization and also in developing new technology and products.
Behind the upturn in business results are fundamental changes in business models. These now put more emphasis on higher stock prices and credit ratings, achieved via wide-ranging improvements in return on equity (ROE), corporate social responsibility (CSR), corporate governance, corporate accountability and disclosure of information in line with international accounting standards. These changes are being accompanied by greater profitability, with not only management but each individual employee thinking, planning, and taking action with priority focused on profits.
As Chart 8 shows, however, the amount of retained earnings, a component of owned capital, started to decline after the collapse of the bubble, with substantial losses being reported up to the latter half of the 1990s. As a result, firms with weakened capital bases were forced to repair the damage by appropriation of current income, giving rise to the abiding impression among management that recovery is still far off. According to a survey of firms by the National Tax Agency, in fiscal 2002 about 20 percent of corporate income was tax exempt due to net operating losses carried forward, and a deficit of more than 70 trillion yen had been carried forward as firms could not offset such losses out of current profits. Furthermore, since ROE still remains at a low level compared to the past (Chart 9), and it would be difficult for management to sustain any rise in labor's share of income, which remains at a historically high level (Chart 10), Japanese firms, like their U.S. counterparts, are likely to continue to depend on outsourcing and use of part-time employees.
3. Prices
Turning to prices, the decline in the core consumer price index (CPI), which excludes fresh foods, is narrowing, with the year-on-year rate of change recently moving at around zero percent as shown in Chart 4. This is due in part to temporary factors such as the increase in medical treatment costs and the tobacco tax as well as higher rice prices. Excluding the effect of these factors, the CPI is likely to remain on a modest downward trend given the persistent output gap. However, three and a half years of continuing year-on-year declines in the Domestic Corporate Goods Price Index came to an end in January and February due to the surge in international commodity prices and shipping rates mentioned earlier. Firms that cannot absorb these price hikes, either by passing them on in their product prices or through rationalization, are having to suspend or reduce production to avoid unprofitable operations and resultant losses. The effects of these movements on business results should be monitored carefully.
4. Ensuring an Autonomous and Sustainable Recovery
It is hoped that continuation of the current positive economic cycle will gradually resolve the problems of balance sheets damaged by asset price deflation, nonperforming loans (NPLs), and above all structural imbalances such as the fiscal deficit. We must not forget, however, that these structural problems are deep-rooted as well as widespread. It is said that the national wealth Japan lost from the bursting of the economic bubble is comparable in percentage terms to the physical damage Japan had suffered from World War II. Looking ahead, the crucial point is whether banks and firms are able to complete balance sheet adjustment before the full removal of the blanket guarantee of bank deposits in April 2005 and the planned introduction of impairment accounting from the business year ending March 2006. Furthermore, firms and households ought to anticipate a greater future financial burden from increased social security payments and taxes to accommodate the lower birth-rate and the rapid aging of the Japanese population. Given these constraints, the present phase of economic recovery needs to be maintained for a considerable period, and to be both firmer and at a higher level, if the economy is to be launched on a sustainable growth path.
To achieve such an objective, the following issues need to be addressed. First, as I mentioned earlier, firms need to further enhance productivity through the use of IT. Second, service sectors, such as the medical, welfare, environment, and education sectors, as well as the farming sector, should be reformed so as to promote greater demand. And third, the international competitiveness of Japan's key industries should be further strengthened. I would like to elaborate on this third point. Key industries such as heavy industry (including steel, shipbuilding, cement, and general machinery) as well as high-technology industries have consistently placed utmost importance on the manufacturing of goods, and this has made possible a horizontal division of labor with other Asian countries. At present, Japan's key industries are indispensable to the rest of Asia as the supply base for these countries' manufacturing activities. Japan is in a position to further expand its production base by improving international competitiveness through further rationalization and the development of new technology and products, as well as by strengthening its links and increasing interdependence with other Asian countries. If the focus on these three central issues is maintained, and efforts drawing on the vigor and potential available at the micro-level continue to enhance the national ability to create added value, there will be stability in the levels of wages and employment, and a more autonomous and sustainable economic recovery will become possible.
C. Financial Developments in Japan
1. Decline in the money multiplier
As for monetary conditions, the Bank's provision of ample funds based on its quantitative easing policy, which I will be discussing later, has brought about substantial growth in the monetary base (the sum of currency in circulation and current account balances at the Bank), as the upper panel of Chart 11 illustrates. However, due to the marginal growth rate of the money stock (M2+CDs), or the amount of money held by firms and households, the ratio of the money stock to the monetary base, namely, the "money multiplier," followed a downward trend from the second half of 1990s until autumn 2003 (Chart 11, lower panel). The sluggishness in both banks' lending and firms' borrowing activities contributed to this movement. With regard to the banking sector, BIS regulations regarding capital requirements obliged banks to restrain lending activities when their capital decreased significantly due to the fall in the value of their stock holdings after the collapse of the bubble and the increase in NPLs. Moreover, as the NPL problem heightened concerns about financial system stability and the credit risk attaching to particular banks, banks' demand to secure on-hand cash increased and their performance of their financial intermediary function declined. On the borrowers' side, firms have been striving to reduce excessive debts and capacity so as to improve their balance sheets. As Chart 12 illustrates, firms have been keeping their business fixed investment below the level of cash flow, and when cash was left over after paying for business fixed investment and operational costs, it was used to repay bank loans. Firms have been accelerating their repayments of bank loans after the financial crisis in 1997-98, because, by pursuing higher stock prices and credit ratings, firms make greater use of market financing, which is less expensive than borrowing from banks. The increased reliance on market financing is also attributable to various pieces of deregulation concerning the issuance of corporate bonds, such as the abolishment of the qualification criteria for corporate bond issues in 1996.
2. The financial environment: recent changes and future prospects
Since October last year, however, Banks' restrained attitude toward extending loans has changed significantly. With their holdings of Japanese government bonds piling up, the recovery in stock prices from a year earlier, and progress in the disposal of NPLs, banks have become more active in extending loans, especially to small and medium-sized firms and households, with loans to the latter mainly in the form of housing loans. Against this background, the pace of decline in banks' lending has been slowing slightly, although it remains on a downtrend (Chart 13). In terms of its effect on economic activity, the increase in banks' lending to small and medium-sized firms has boosted the latter's capital investment, and this has helped strengthen economic activity. Although some problems remain at individual banks, the Japanese financial system as a whole has been increasingly stable. This is due to the schemes for injection of public funds, namely that in accordance with Article 102 of the Deposit Insurance Law and the proposed alternative scheme worth 2 trillion yen, as well as banks' efforts to advance the disposal of NPLs. Given the improvement in banks' lending behavior and the increasing stability of the financial system, the foundations are now in place for an acceleration in the growth rate of the money stock in the future.
For the growth rate of the money stock to rise, it is not only prerequisite that banks' lending attitude improve, but there must also be an increase in firms' demand for bank loans. It is not easy, however, to bring the declining trend in bank lending to a halt, and then to turn it around, when firms are changing their business models as I described earlier. Cash flow is central to firms' financial management strategies, and, courtesy of substantial improvements in their cash flow situations, large firms that performed poorly in the past are now paying back a large amount of their outstanding bank loans, so that the problem of excessive firm debts has been to a large extent resolved already. As reported recently in the newspapers, there are many firms that have resumed or increased their dividend payments, following an extended period of cancellation or reduction. Turning to firms' policies on investment, these are no longer determined by the decisions of competitors, in contrast with the bubble economy period. Instead, investment decisions are beginning to be made based on careful examination of rates of return on investment, or more specifically, based on projection of the expected cash flow to be generated from investment in land, businesses, or particular projects. Such changes are also evident in the United States and the euro area, and as a result banks' lending to firms in these regions has been declining or sluggish, as shown in Chart 14. Japanese banks will have to continuously review their own business management strategies in line with changes in borrowers' business models. Otherwise, it will be difficult to increase profitability and attain further stability in their business activities. I would like to touch later in my speech on some management issues attending banking business in future.
II. Quantitative Easing Policy of the Bank
Let me turn now to the Bank's monetary policy response to date to the economic and financial situation in Japan, namely the quantitative easing policy. I assume most of you are already familiar with the aims and implementation of the quantitative easing policy. Please refer to Chart 15 for an outline of the policy. Today, I would like to focus on some issues of current relevance to the quantitative policy: these include the measures adopted last October to enhance the transparency of policy commitment, the raise in the quantitative target this January, and other issues regarding future policy implementation.
A. The Enhancement of the Transparency of the Commitment to the Quantitative Easing Policy
The first topic relates to the measures to enhance the transparency of the commitment to the quantitative easing policy, specifically, the clarification of the criteria to be met before discontinuation of the current quantitative easing policy. As indicated in Chart 15, the Bank has publicly committed to continue the quantitative easing policy until the year-on-year increase in the core CPI steadily registers zero or above. The surge in interest rates on short-term futures last summer was attributed not only to the rapid increase in stock prices and long-term interest rates, but also to the discussions and members' comments made at the Bank's Monetary Policy Meetings (MPMs) regarding the conditions surrounding discontinuation of the quantitative easing policy, i.e. regarding the implementation of the so-called "exit" policy. Even though economic activity is improving, the Bank's primary policy objective is to continue the quantitative easing policy as long as prices continue to fall, while the exit policy is a subsidiary issue. It was to ensure the market's mutual understanding of the Bank's priorities in this regard that the criteria for discontinuing the quantitative easing policy were made public last October.
Sometimes the view is expressed from outside the Bank that "it has intentionally sealed the discussion on exit policy in order to maintain the duration effect of the commitment policy." However, the criteria announced last October in themselves constitute the Bank's stance regarding exit policy. The Bank's primary objective is to overcome deflation through continuing the current monetary policy. After this objective is achieved, it is safe to say that the Bank's subsequent implementation of monetary policy will be based on a careful consideration of how market participants' views on economic activity and price development are reflected in the curvature and movement of the yield curve and how these will affect the money market.
B. The Monetary Easing Measures Taken in this January
Regarding the second point, that is, the monetary easing measures taken this January, some outsiders asked us "why the Bank pursued further monetary easing policy when the economy is already in a recovery phase." In my opinion, the measures were indispensable for the following reasons.
1. Dealing with Deflationary Risk in the Economy
The first reason is described in the Bank's January policy statement: "in order to reaffirm its policy stance to overcome deflation and ensure a continued recovery." To elaborate on this point, the Bank considered it necessary to demonstrate the flexibility of its policy stance at a time when the deflationary impact arising from the appreciation of the yen became a concern to the Japan's economy. In the Bank's Outlook and Risk Assessment of the Economy and Prices, which was released shortly after announcing the criteria for discontinuing the quantitative monetary easing policy, most of the policy board members projected that, over the current and following fiscal years, Japan's economy would continue to recover but at the same time that the fall in prices would continue (Chart 16). At the November MPM, one member expressed the view that it was necessary to reinforce understanding that, even when the economy started to recover, the Bank would maintain the quantitative easing policy as long as prices continued to fall. In addition, the Bank should continue to conduct money market operations in a flexible manner to deal with a possible surge in liquidity demand. In the meantime, as the pressure for appreciation of the yen has accumulated in the foreign exchange market, the negative impact of a possible further appreciation of the yen on exports and corporate profits became a source of economic concern. Under such circumstances, the Bank considered it necessary to mitigate the deflationary impact by creating public expectation that the current extremely easy monetary conditions would be maintained for the foreseeable future.
2. Securing Smooth Conduct of the Bank's Market Operations
The second reason was to secure enough leeway in the target range for current accounts at the Bank to ensure that the surge in the issuance of financing bills (FBs) accompanying the increase in foreign exchange intervention did not disturb the Bank's market operations and so impede the Bank's efficient communication with the market. As Chart 17 indicates, the amounts outstanding of FBs and treasury bills (TBs) in the money market are increasing rapidly. However, although it might take some time, newly issued FBs and TBs are likely to be absorbed smoothly in the market and the yields on FBs and TBs should be consistent with other relevant market interest rates. From the viewpoint of the asset-liability management (ALM) of private banks, it is desirable that the terms of financing on funds raised for investment in FBs and TBs should be as close as possible to the maturity of the securities purchased, namely three months, six months and one year. However, with the zero interest rate prevailing in the money market, and the removal in April 2002 of blanket deposit insurance for all bank liabilities sparking concerns about credit risk at individual banks, raising funds with relatively long maturities of three-months to one-year from the markets is difficult for private banks, who are therefore dependent upon the Bank's market operations for such financing. In fact, as Chart 18 shows, the bid-to-cover ratio for the Bank's longer term funds-supplying operations has remained at a high level, and this seems to have been caused in part by the high level of FB issuances. Liquidity demand in the money markets should be monitored closely, with a view to securing market stability.
3. Preparing for the full removal of blanket deposit insurance
The third reason may be described as the Bank using monetary policy to "buy insurance." This was considered appropriate in order to minimize the negative effects of financial system problems on Japan's economy, since the full removal of blanket deposit insurance scheduled for April 2005 leaves only one year to solve the financial system's problems. During this period, Japan's economy should do everything it can to avoid a financial crisis, such as that in 1997-98, and the resultant damage to economic activity. My view is that the Bank should continue its current quantitative easing policy not only until deflation is overcome but also until Japan's financial system has proved to be stable. Furthermore, the Bank should maintain its easy monetary policy stance until balance sheet adjustments by private banks and private firms are safely within sight of completion.
C. The Effects to Date of Quantitative Easing and Associated Side Effects
1. Effectiveness of quantitative easing
The quantitative easing policy has come up against the criticism, driven by a focus on final outcomes, that it keeps alive ailing firms and that, if interest rates were allowed to rise, this would speed up the process of selecting stronger firms and would hasten the economy's return to health. Although I do not assume a priori that it is desirable to keep ultra-low interest rates in place forever, nevertheless maintaining such low rates for a long time has reduced the interest rate burden on firms and banks, thereby supporting the process of industrial change and reorganization as well the revitalization of firms and the disposal of NPLs. The recovery in international competitiveness of the iron and steel, shipbuilding, cement, and other manufacturing industries, the recovery in profitability witnessed in nonmanufacturing industries such as shipping, electricity, and nonbank financial services, as well as the evidence of banks regaining enough financial strength to engage in competitive lending, all these undoubtedly owe much to the efforts of individual firms and banks to restructure themselves and cut excess labor and capacity. However, it has been the maintenance of ultra-low interest rates that has underpinned these restructuring efforts. In addition, when we consider that this recovery in the earnings of firms and banks, by reducing bankruptcies, increasing the number of employees, and causing share prices to rise (see Chart 19), has also played a role in the improvement in private consumption and the curtailment of the rate of decline in consumer prices, then the criticism of the quantitative easing policy for preserving ailing firms appears one-sided. It would be fairer to say that the positive effects of the quantitative easing policy on the economy, employment, and prices, are becoming steadily more evident, even if with a time lag.
When thinking about the lagged effects of monetary policy, the words of Federal Reserve Chairman Alan Greenspan on the occasion of his visit to Japan in 1992 come to mind. He argued against those who claimed that the Federal Reserve's interest rate reductions, of which there had then been 24 consecutively, were ineffective, stating that in a situation where the economy was facing balance sheet adjustments, it would require considerable time for the effects of monetary policy to become apparent via a lightening of the corporate debt burden. At the same time, he predicted that Japan would find itself facing similar problems, including asset price deflation, in future. In the United States today, following the collapse of the 2000-01 IT bubble, and in spite of the accompanying fiscal expansion to stimulate the economy, there have now been a total of 13 interest rate reductions over a period of three years.
In Japan, on the other hand, the last economic peak was three and a half years ago in October 2000, and three years have passed since the subsequent introduction of the quantitative easing policy. The economy itself hit bottom in January 2002, and since then has been recovering gradually. However, in contrast with the United States, the significance of the current economic recovery is that it is not dependent upon fiscal expansion, but has been driven by reforms on the microeconomic level. I have said earlier that the key to ensuring that the economic recovery becomes autonomous and sustainable lies in pushing forward with such microeconomic reforms. However, as I mentioned above, it is also vital that monetary policy is used to support these microeconomic reforms within the constraints imposed by maintaining fiscal discipline, and in the context of reforming government expenditure and the regulatory environment. For these reasons, keeping a cautious eye upon the various structural problems pointed out earlier and their influence on the economy and the financial system, we must maintain the current quantitative easing policy patiently until we have escaped from the deflationary trend and the stability of the financial system is restored.
2. Side effects of quantitative easing
It is a fact, however, that there are side effects that accompany the positive effects of the quantitative easing policy. In this regard, the Bank has consistently taken into account the relative weight of each of these in its conduct of monetary policy to date, however my own personal impression is that, amid the economic upturn and with the stability of the financial system as a whole continuing to improve, the gap between the positive effects and side effects of the quantitative easing policy is somewhat less pronounced than it once was.
Side effects of the quantitative easing policy do not end with the diminished functioning of the interest rate in the market, reductions in households' income from interest, and the impeding of the investment activities of pension funds and other institutional investors. They also include, as was seen in Chart 17, the large-scale reductions in activity seen in the call market for short-term inter-bank lending, particularly in the trading of unsecured call money. Concerns regarding moral hazard have also been voiced, as the shrinking of the call market has meant that banks' longer term fund procurement has become unduly dependent upon the Bank's market operations. These are concerns which I share. As banks' ratings rise along with progress in the disposal of NPLs and the strengthening of their profitability, and as market confidence in the stability of the financial system rises with the full removal of blanket deposit insurance, the hope is that there will be renewed activity in the short-term financial markets, including deals involving longer-term funding, and that the result of this will be a return to a situation in which banks' ALM is conducted through markets in an autonomous and fully flexible manner.
III. The Future of Banking Business
I have just mentioned banks' progress in dealing with NPL problems and their rising profitability, and in this regard, as the fall in the amount of NPLs outstanding and the recovery in business results indicate, the overall situation is improving. In this context, the fact that major banks continue to articulate fresh strategies is extremely encouraging. It is to be hoped that this positive trend continues, but the issue of key importance here is that banks respond to firms' needs and develop further the advisory services that they offer.
If we look to specify the firm needs being referred to, one of them is that banks become partners with firms, taking a share of the risks that the latter face. For this reason, there are three points which are of particular significance to the banking side in future: first, they must improve the sophistication of their risk management, including at the frontlines of their sales and business operations; second, they must enforce restrictive financial covenants and clarify the division of risk and return associated with a project between lender and borrower; and third, in response to the changes of the time, they must carry out continuous strategic reviews of each of the financial areas with which they deal, in other words of their entire business portfolio. I'd like, finally, to elaborate a little upon these three points.
A. Improving the Sophistication of Risk Management
1. Promoting the integrated operation of front and back offices in terms of risk management
On the first of these points, improvement in the sophistication of risk management, I should like to point to the dispersion of risk that is achieved in large U.S. banks. A fully automated and standardized system links front offices and risk management sections seamlessly together, and the risks associated with all in-house assets are continuously evaluated: if the results of this evaluation suggest that a given asset carries a liquidity risk, that asset is securitized and sold; if there is a concentration of risk, then in addition to disposal via securitization, derivatives are used to provide a hedge, and so on. Just as in a dealing business, core assets are preserved, while assets carrying risks that exceed the tolerated range are disposed of with an eye on market conditions. Recently in Japan we have begun to see movements at both large and regional banks toward improving the sophistication of their management of credit risk, and it is to be hoped that these develop into a wider trend.
2. Enhancement of the functioning of markets for asset-backed securities (ABSs)
Ideally, in order for banks to continually review the quality of their assets, it is desirable to have in place markets where banks can buy and sell assets whenever they wish. In order to achieve this, banks must make constant use of market price valuation and impairment accounting to carry out appropriate self-assessment of their assets. As a temporary measure, which began in August 2003, the Bank has been carrying out purchases of ABSs, for example those backed up by loan claims. On the strength of the Bank's purchases, it is hoped that markets for ABSs will expand. Moreover, if, following the necessary legislative adjustments, we were also to witness the expansion of markets for other securitized assets and credit derivatives, as well as of peripheral markets such as those for buying and selling loans themselves, we would expect this to make it easier for banks to provide more appropriate self-assessments. The Bank carried out a review of parts of its scheme for purchasing ABSs in January this year, with a view to making it easier for market participants to use it. With the cooperation of relevant government offices and financial institutions, we intend to hammer out a mechanism that will enable the market to expand under its own steam in future. In this regard, we have put together a pamphlet that provides a simple summary of recent efforts to diversify the available means of corporate financing, including via ABSs, which I have distributed for your reference today.
B. Clarifying Risks and Returns
Turning to the second of the points, clarifying the risks and returns associated with individual borrowers by utilizing covenants, the premise here is the need for banks and firms together to exert every conceivable effort to minimize the risks and maximize the returns of every project up for consideration. Such efforts will contribute to improving banks' ability to evaluate projects effectively. In the case of regional financial institutions, whose lending business has traditionally been characterized by relationship banking, it is to be hoped that they will continue to play a central role in nurturing local enterprise and securing the foundations of the local economy. However, this is not to say that, because it is being done for a good cause, it is acceptable to neglect the obligation to secure profitability. It is vital that, paying due attention to shareholder profits, these institutions provide rational forecasts of and make sensible arrangements with regard to profitability of a project and the division of the risk associated with a project between lender and borrower.
C. Continuous Strategic Review of Business Portfolios
The third point was the continuous review by each bank of its business portfolio. In an age when changes are sudden and sharp, preserving the stability of banks' business requires that they allocate their resources selectively and intensively, reviewing their business portfolios from a strategic perspective in response to changes in the business environment and in the management resources at their disposal. In the United States, the financial industry is constantly being reorganized through strategic M&A, as illustrated by the merger of JP Morgan Chase and Bank One, or the take-over of Fleet Boston by the Bank of America. A few days ago, there were reports of acquisitions activity taking place among regional banks in Florida. These kinds of active M&A lie behind the reported absence of over-banking problems in the United States, and what makes them possible is an accounting culture steeped in the principles of impairment accounting and the use of market price evaluation, as well as the principles of thorough reporting and full accountability, so that share prices are formed which adequately reflectfirms' fair values. Recently, it is encouraging to see that in Japan too banks have been making strategic moves toward expanding sections dealing with individual clients and small and medium-sized firms. It is to be hoped that banks continue to preserve their core businesses, while seeking to improve the selectivity and intensiveness with which their resources are allocated. My own opinions on the key business areas for banks in future are summarized in Chart 20, however I would like to supplement this with some brief comments on banks' international business. Japan is the world's largest creditor nation and Japanese firms are expanding their operations overseas. In addition, the lending spread abroad may be thought more rational than that available domestically. For these reasons, it would be desirable to see Japanese banks once again active on the world stage, and increasing their presence in overseas markets. Major banks are already strengthening the systems they have in place in China and other Asian countries where Japanese firms have been expanding their operations, and we hope that such efforts will lead to further increases in bank profits.
Concluding Remarks
I have spoken in some detail about the economic and financial situation both at home and abroad as well as about the Bank's monetary policy. In closing, I would like to stress once more that, in order for Japan to steadily regain the national wealth lost in the collapse of the bubble and to lay the foundations for future generations, it is absolutely essential, as I have now repeated several times, for government expenditure and the regulatory environment to undergo reform and, at the same time, for firms and banks not to rest on their laurels, but to strive continually to transform themselves, continuing the microeconomic reforms needed to raise the entire country's ability to produce new value-added, and to ensure that economic growth is autonomous and sustainable.
Everyone knows that Nagasaki is blessed with a rich history, culture, and natural environment, which lie behind its flourishing tourist industry and abundant fishing resources. It also lies in close proximity to rapidly growing China, and with the first scheduled seaway from Shanghai to Japan having been established, its fortunate geographical situation has deep historical roots. By making greater use of these local characteristics and advantages, it should be perfectly possible to stimulate local economic activity further. In this regard, closer ties with China and other Asian countries in the growth region may be thought the key point. In the shipbuilding industry, on the back of increased worldwide distribution based on economic growth in China and other Asian countries, repeated efforts to rationalize operations have already developed into a recovery in business performance. I also saw in the newspaper the other day an article saying that next month Nagasaki Gyoren (the fisheries association in Nagasaki) will establish a new office for identifying business opportunities in China. This is based on the expectation that, although China is currently the world's largest exporter of fishing produce, in future, as its domestic demand expands, it is likely to turn into an importing country. From the point of view of involvement with the rapidly growing China, the activities of Nagasaki Gyoren are the focus of considerable attention. Similarly, although the public and private sectors have joined forces in their promotional efforts on behalf of the prefecture's largest industry, tourism, the most effective measure to develop the industry further would surely be to target tourists from foreign countries such as China. For your reference, I have produced a summary of future corporate strategic targets (Chart 21).
I would like to finish my speech today by expressing my earnest hope that Nagasaki, famous throughout the whole country as a culturally advanced and sophisticated region, will create an economic structure more open to the rest of the world and make further great strides forward. I also hope that as more and more regional economies make such progress, a New Japan will be born: a country with a powerful vision for the future, where people are proud to live. Thank you for your kind attention.