Summary of a Speech Given by Hidetoshi Kamezaki, Member of the Policy Board, at a Meeting with Business Leaders in Yamagata on May 29, 2008 (Recent Economic and Financial Developments in Japan) : 日本銀行 Bank of Japan

Summary of a Speech Given by Hidetoshi Kamezaki, Member of the Policy Board, at a Meeting with Business Leaders in Yamagata on May 29, 2008

August 4, 2008
Bank of Japan

I. Developments Overseas
II. Developments in Japan's Economy
III. Slowdown in Economic Growth: Turning the Challenge to Achieve Sustainable Growth into an Opportunity
IV. The Bank's Conduct of Monetary Policy
Conclusion

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I. Developments Overseas

For most of the three decades since the early 1970s, the global economy has grown at an average rate of around 3 to 4 percent. In the past few years, the growth rate was as high as around 5 percent. Recently, however, a slowdown has become evident, especially in the U.S. and European economies. Nevertheless, according to the IMF's April 2008 World Economic Outlook, global economic growth, supported by robust growth in emerging economies, is expected to be 3.7 percent in 2008 and 3.8 percent in 2009, although downside risks to the global economy are increasing.

In the United States, large-scale adjustments in the housing market have persisted, and a decline in nonfarm payroll employment has continued for four months and is observed in a wider range of industries. Coupled with this, the tightening of lending standards by financial institutions and the surge in gasoline prices have led to a deterioration in consumer confidence. As a result, private consumption has slowed substantially, staying flat recently. In relation to this, the year-on-year rate of increase in sales tax revenues for all 50 states, which has largely reflected developments in private consumption for the past 20 years and registered 6 to 10 percent from 2004, has fallen below 5 percent since the October-December quarter of 2006 (Chart 1-1). Looking at developments by state, sales tax revenues of states with declining housing prices have tended to either fall or increase only slowly (Chart 1-2). With the decline in housing prices spreading to a wider range of regions, the effects of the housing market adjustment on private consumption are likely to become more evident. As a result, private consumption is expected to remain sluggish, even with the positive effects of the income tax rebate. In addition, business fixed investment has also been somewhat weak, due to the slowing growth in corporate profits and also partly due to the tightening of lending standards by financial institutions. Given these developments, the U.S. economy is likely, for the time being, to experience sluggish growth, or even a moderate recession. Some economic indicators, such as housing starts and sales, the year-on-year rate of change in housing prices, and the Reuters/University of Michigan Index of Consumer Sentiment, have declined to their lowest levels since the early 1990s -- when the economy fell into a state of recession due to the nonperforming-loan problem involving land, less developed countries, and leveraged buyouts, or the "3Ls" problem -- or even further to their lowest levels since the early 1980s -- when the savings and loan crisis hit the economy. In the financial sector, while the number of failed or troubled financial institutions has not increased significantly, indicators of financial institutions' profitability such as return on equity and return on assets have declined to their lowest levels since the early 1990s, reflecting the increased amount outstanding of nonperforming assets relative to total assets. These developments suggest there is a risk that the downturn in the U.S. economy will be protracted and severe.

The economy of the euro area is expected to continue to grow, but the pace of growth is likely to slow due to the effects of the deterioration of the U.S. economy, the tightening of lending standards by financial institutions, the appreciation of the euro, and the adjustments in housing markets in some countries such as Spain and the United Kingdom. As for European emerging economies such as countries in Central and Eastern Europe and the Baltic states, which have been growing rapidly supported by the flow of funds from industrialized countries in Europe, there is a risk that the tightening of lending standards by European financial institutions may lead to a drying up of this flow of funds and instability in these economies.

I will now touch upon the current situation in financial markets in the United States and Europe, which has been curbing economic growth there. Increased concerns about the valuation of securitized products backed by subprime mortgage loans -- mortgage loans to borrowers with insufficient repayment capabilities -- have caused large-scale adjustments since summer last year in a broad range of credit markets involving securitized products, corporate bonds, and credit derivatives. This has led to strains in money markets, in which financial institutions conduct their day-to-day short-term borrowing and lending. These disruptions in U.S. and European financial markets are yet to reach an end. Under these circumstances, U.S. and European financial institutions have secured short-term funds and have bolstered their capital promptly while ensuring public confidence in them through speedy identification and disclosure of losses incurred. Meanwhile, central banks have also taken action. The U.S. Federal Reserve, in addition to undertaking flexible and substantial rate cuts, has taken prompt and drastic action to maintain money market stability since fall last year. Examples of such action include the establishment of a temporary Term Auction Facility, the expansion of the Term Securities Lending Facility, and the introduction of the Primary Dealer Credit Facility. The European Central Bank and the Swiss National Bank have established temporary foreign exchange swap lines with the Federal Reserve to conduct operations providing money markets with dollar liquidity. The Bank of England has also reacted flexibly to the disruptions, increasing the amounts, as well as expanding the range of counterparties and collateral, of its term repo market operations. Nevertheless, more time will pass before markets stabilize, since the disruptions, which are deep-rooted, have led to an increase in nonperforming assets at U.S. and European financial institutions and in turn have negatively affected economic activity.

As for China, despite concerns about a slowdown in external demand, its economic growth remains high due to strong domestic demand in areas such as fixed asset investment and private consumption. Prices, mainly of food, have been rising rapidly and the effects on the economy and society are of great concern, and future developments in demand remain highly uncertain. Countries exporting natural resources, particularly those in the Middle East and Russia, are expected to maintain high economic growth due to the increasing inflow of income resulting from high resources prices, and therefore risks of overheating of these economies warrant attention.

II. Developments in Japan's Economy

Japan's economic growth is slowing, mainly due to the effects of high energy and materials prices. In the April issue of the Bank's Regional Economic Report, the assessment of economic activity was revised downward for eight out of the nine regions compared with the January report. The only exception was the Hokkaido region, the weakest among all the regions, for which the assessment remained unchanged. The economy of the Tohoku region, which includes Yamagata Prefecture, was described as continuing to recover gradually in the January report, but this assessment was revised downward in the April report, which stated that the economy seemed to have stopped recovering. These developments indicate that the slowdown in the economy is becoming more evident in a wide range of regions, and thus future economic developments warrant attention. Taking Japan's economy as a whole, deceleration seems likely to continue for the time being due mainly to the slowdown in overseas economies and the effects of high energy and materials prices. Thereafter, however, as the Bank's baseline scenario assumes, the economy is likely to follow a path of moderate growth, as overseas economies are expected to move out of their deceleration phase and firms currently face no pressures to adjust employment and production capacity.

A. Developments in the Corporate Sector

Let me now look at the corporate sector in detail. Exports overall have been solid, reflecting the strong growth of overseas economies. However, exports to the United States, Spain, and other countries where economic deceleration has become more pronounced have been relatively weak recently. Since exports have been a driving force of Japanese economic growth, due attention should be paid to developments in exports, including the effects of the slowdown in overseas economies and the appreciation of the yen.

Corporate profits of large firms have marked new record highs for several years, but their growth is likely to weaken due to the economic slowdown at home and abroad, the rise in materials prices, and the appreciation of the yen. Moreover, business sentiment has been deteriorating. Under these circumstances, the pace of growth in business fixed investment is likely to decelerate as firms have been paying added attention to investment efficiency in conducting new investment projects. Nonetheless, as firms currently face no strong pressures to adjust production capacity, they are likely to carry on investing with the aim of meeting medium- to long-term demand as well as rationalizing production and saving labor in order to adapt to an aging society. Therefore, business fixed investment is likely to remain firm.

B. Developments in the Household Sector

The flow of income from the corporate sector to the household sector, the key to economic growth, has been increasing only slowly. As for employment and income, labor market conditions have tightened, and the number of employees has been rising. Nonetheless, it remains unlikely that wages will increase significantly, because of two factors. The first is economic globalization. Firms are restraining domestic labor costs in the face of intensifying global competition and the need to consider adequate compensation of employees not only of parent firms but also domestic and overseas consolidated firms. The second factor is the effects of successive revisions of the laws governing employment since the late 1990s. The revision in 1999 enabled a wide range of industries to employ temporary workers dispatched from agencies, and that in 2004 allowed manufacturers to employ such workers. As a result of these revisions, the number of non-regular employees has increased sharply, and this has been pushing down the level of average wages. Given the recent tightening of labor market conditions and growing public interests in working conditions of non-regular employees, firms have increasingly been employing former non-regular employees as regular employees. If as a result the proportion of part-time workers in the workforce continues to decline, this may eventually exert upward pressure on wages. On the other hand, at small firms, labor's share of income is already quite high and it therefore seems unlikely that wages at such firms will rise significantly. Even large firms, where labor's share of income is relatively low, seem to face difficulties in raising wages considerably due to the recent deterioration in the income environment. Nonetheless, reflecting the increase in the number of employees, aggregate household income has been increasing.

In this employment and income situation, although private consumption is likely to remain firm, its growth currently lacks strong momentum and may continue to be negatively affected by the rise in gasoline prices, developments in stock prices, and concerns about the social security system. Looking back at developments from a longer-term perspective, private consumption accounted for about 60 percent of real GDP in the early 1980s, but its share has declined gradually to the 55-60 percent level recently, contributing less to economic growth (Chart 2). Since the Japanese economy has already matured, it is not reasonable to expect strong growth in private consumption unless the environment changes markedly through a large increase in household income or the introduction of new products and services that boost demand.

As for housing investment, although the effects from the revised Building Standard Law have faded compared with some time ago, the number of housing starts has recovered only moderately due to the softness in sales of condominiums.

C. Price Developments

In international commodity markets, prices of natural resources and crops have surged for some years in a closely interrelated fashion as a result of growing global demand, particularly from emerging economies, oligopolistic market structures, supply bottlenecks resulting from delayed improvements in transport infrastructures, and speculative inflows of funds. In addition, the range of commodities whose prices are rising has been expanding. These developments have been increasing inflation pressure globally. In Japan, the corporate goods price index continues to rise rapidly and the increase in the consumer price index (CPI; excluding fresh food) is accelerating gradually. Looking at the movements in the 521 items in the CPI basket, the number of items showing a price rise has been exceeding that showing a decline since August 2006 and the difference has been widening (Chart 3). In the most recently released CPI (excluding fresh food), for March 2008, the number of items showing a price rise exceeded that showing a decline by 118 items. As for food products, despite the fact that the weight of each item is small, the long-lasting rise in their prices and the increase in the number of items whose prices have risen mean that the contribution of these products to the rise in the CPI has also increased: the rise in prices of food products accounted for 0.4 percentage point in the 1.2 percent rise in the CPI for March. The year-on-year rate of change in the CPI for all items less energy and food turned positive, registering 0.1 percent, suggesting that there are a number of items whose price rises are moderate but steady and persistent.

D. Financial Developments

In the financial sector, although the losses incurred by Japanese financial institutions from investments related to U.S. subprime mortgage loans have been increasing gradually, these are contained within the institutions' current profit levels and capital strength. Under this situation, Japanese financial markets, including the money market, have generally remained steady compared with their European and U.S. counterparts. Corporate finance is generally accommodative. However, an increasing number of small and very small firms responded to a survey that their financial positions are tight. This may be due to the deterioration in their earnings environment and the change in their perception of financial institutions' lending attitudes. I will pay careful attention to these financial developments.

III. Slowdown in Economic Growth: Turning the Challenge to Achieve Sustainable Growth into an Opportunity

Japan's economy has been growing at an annual rate of around 2 percent for several years. However, households and small firms, as well as local economies as a whole, do not seem to be greatly benefiting from the current economic growth because of the following reasons. First, the rate of economic growth itself is not especially high partly due to the fact that Japan is a mature economy. And second, unlike large firms as well as metropolitan economies as a whole, households and small firms, as well as local economies, are linked only loosely to the global economy, whose expansion is the source of the current economic growth. Japan's economic growth has recently been slowing, and this deceleration is threatening the achievement of sustainable growth. Looking at the situation differently, however, the economy still has growth momentum, and this leaves a great opportunity, both for the private and public sectors, to review their strategies comprehensively and implement reforms with a sense of crisis, with the aim of increasing the capacity of Japan's economy to realize sustainable growth. In this context, the following issues are key.

A. Further Expansion of Overseas Activities

1. Overseas activities by firms and financial institutions

Further declines in and aging of the population in Japan are likely to restrain its economic growth. The global economy, despite its recent deceleration, is expected to grow at a rate of 3.5-4.0 percent in the coming two years -- higher than Japan's growth. Japanese firms have diversified the destination of their exports and have established an export structure largely independent of economic developments in a particular destination. In addition to this export structure, manufacturers' overseas activities have benefited from high global economic growth, leading the surplus in Japan's income balance to exceed the trade surplus and providing a source of further economic growth in Japan. Recently, even domestic demand-oriented industries -- such as providers of food products, food services, and daily necessities -- have expanded into foreign countries. The rising purchasing power of the growing middle classes in China and India has increasingly provided Japanese firms with business opportunities. Small firms also are gradually increasing exports and expanding overseas business activities. This situation underscores the growing importance for Japan of further strengthening its connections with overseas economies by concluding more economic partnership agreements (EPAs) and free trade agreements (FTAs). Globally, the number of bilateral or multilateral FTAs and EPAs has surpassed 200, but Japan so far has been involved in only nine EPAs and has not entered any agreements with many of its major trading partners.

Japanese financial institutions are gradually increasing their support for firms' overseas activities, and it is hoped that Japan's financial industry will raise its global presence, develop its strength as an information-intensive industry, and, not only by supporting firms' overseas activities but also by invigorating Japan's financial markets, become a pillar of economic growth. Japanese firms and financial institutions will continue to face the need to flexibly modify their behavior to adapt to changes in the situation and make the most of high global economic growth.

2. Global standards and the discipline they exert on firms and financial institutions

In order for Japanese firms and financial institutions to further expand their overseas business activities, they should raise their international competitiveness by enhancing information and innovative capabilities and risk management. Europe, which has made progress in economic integration, in recent years has set up common regional standards with regard to, for example, the environment, the quality of food and chemical products, and the accounting system. These standards -- which were set in a way that transcends the national interests of individual countries -- are of vital significance and set a powerful example. There are many instances in which European standards have been applied to non-European firms running businesses in Europe and eventually became de facto global standards. For firms, meeting these standards represents a cost, but at the same time, the imposition of appropriate external discipline helps firms to improve their risk management and innovative capabilities and as a result strengthen their business. In fact, some Japanese firms doing business in Europe have voiced positive opinions suggesting that complying with advanced and strict European standards will contribute to their global competitiveness. In the future, Japan should not only meet external standards but also be more involved in standard setting. This would reduce obscure standard-setting processes and stimulate corporate activity, eventually bringing about a better business environment.

B. Inward Direct Investment

The expansion of Japanese firms' overseas activities benefits the domestic economy via, for example, an increase in manufacturers' exports of materials and machinery equipment to be used in overseas production and of industrial and construction machinery. In addition to such outward direct investment, it is similarly important that Japan promote inward direct investment. Inward direct investment -- acquisitions of Japanese businesses by foreign investors with the aim of participation in management -- has recently been increasing gradually, but still remains low compared with other major economies (Chart 4). An impression among foreign investors that regulation in Japan is obscure and its market therefore closed has also been suggested as a hurdle for inward direct investment.

Given that Japan's outward direct investment is likely to continue to increase, Japan should attract more inward direct investment. This would open up more opportunities for Japanese firms to strengthen their global competitiveness through strategic tie-ups with foreign capital. An increase in inward investment could also bring macroeconomic benefits, as a diversification in Japanese firms' management -- or participation in management by various types of investors including foreign ones -- could reduce swings in business fixed investment stemming from domestic factors and thus increase the robustness of domestic demand.

C. Securing Sufficient Human Resources and Improving Labor Productivity

It has been estimated that Japan's population will decline to 80 million by 2060, which would be less than that of the United Kingdom, whose current population is around 60 million. If this turns out to be the case, the rapid decline in population combined with aging would put economic growth and social vigor at risk. Currently, the number of immigrants in Japan is about 2 million, only 1.6 percent of its population. It is noteworthy that the ratio of immigrants to the population overall in the United States, Germany, and the United Kingdom -- all of which have been posting long-term and sustainable economic growth -- is as high as 14.5 percent, 12.7 percent, and 9.4 percent, respectively. In countries with a large number of immigrants, however, the increase in immigrants has caused certain social problems, and some countries have revised their liberal immigration policies accordingly. As not only the United States and European countries but also emerging economies are gaining strength, Japan should take the current situation more seriously and act promptly to secure necessary human resources in the international market before it becomes too difficult. I hope that a long-term and comprehensive approach will be taken soon regarding this issue.

Moreover, it is also important for Japan to increase labor productivity. For this purpose, Japanese firms should treat workers fairly. For instance, a lot of improvement is required in staff training. Since a large number of baby boomers have been retiring, it is vital to ensure that the skills and expertise of firms in the manufacturing sector and various other sectors are steadily passed on to the next generation. It is also important that firms ensure employees have a healthy work-life balance, non-regular employees receive training, and the status of non-regular employees is changed to that of regular ones. Firms' efforts in these directions should not be so extreme as to harm their competitiveness in the long run. However, it is fundamental to have sufficient skilled labor to achieve sustainable growth of both Japanese firms and the economy as a whole. To this end, firms should devise strategies to ensure that as many employees as possible are satisfied with their job and are more productive, and to encourage them to stay in their job for a long period of time.

D. Issues Relating to Natural Resources and the Environment

The recent surge in prices of natural resources and food, which has led to inflation in importing countries and a decline in corporate and household income in real terms, has been threatening not only global economic growth but also social stability worldwide. For Japan's economy to realize sustainable growth, it is crucial to secure sufficient amounts of natural resources and food supplies. Unfortunately, however, there have been an increasing number of cases where Japanese buyers fail to compete with their rivals in international commodity markets. Japan needs to strengthen its capacity to procure natural resources and food by getting involved in activities at the source of production, for example, mine development for mineral resources and the management of local farms and factories for food. Both the public and private sectors are now facing the need to plan and put into action a medium- to long-term strategy for achieving sustainable economic growth, taking fully into account the risks involved. In some cases, more participation in EPAs and FTAs, which I described earlier, may be a prerequisite.

Dealing with environmental issues is also indispensable for sustainable growth of not only Japan's economy but also the global economy. In particular, constraining global warming has become a major political issue. Parties to the 1997 Kyoto Protocol are now required to reduce greenhouse gas emissions to a certain level by 2012. While Japanese firms need to reduce their greenhouse gas emissions, there is high expectation that -- by making the best use of their advanced technology that is environmentally friendly and supports efficient use of energy -- they will create new global business and, at the same time, contribute to solving the problem. Environmental issues are one of the areas in which Japanese firms can demonstrate leadership, and it is hoped that they will make a large contribution in many aspects. Action by Japanese firms will be able to reduce global consumption of natural resources and mitigate the severity of the resource problem.

E. Avoiding Large Swings in Economic and Financial Activity: Learning from the Past

Long-lasting economic growth tends to cause a buildup of economic and financial excesses at some point, threatening further growth. The recent turbulence in global financial markets can be seen as an example of a situation in which the risk assessment by market participants became slack amid long-lasting, favorable economic and financial conditions, and a correction in the markets followed. In hindsight, such developments are considered a natural course of events. However, history shows that memories of financial events tend to fade after a relatively short period of time and that each of the economic bubbles in the past differs in type, and this is why people are usually not alert to the seriousness of these kinds of developments.

Common factors behind the emergence of previous economic bubbles that have been highlighted include accommodative financial conditions, rising asset prices, a bullish mood, the development of leveraged, high-return financial products, and the appearance of financial genius. It goes without saying that, due to the expansion of the market economy and the progress in economic globalization, the economy and financial markets are constantly undergoing changes and are experiencing many unprecedented events. Notwithstanding, it is important for firms, financial institutions, and also the public sector to be humble and learn from past events -- those that occurred not only in Japan but also worldwide -- so that they can capture the essence of current economic and financial phenomena and avoid large swings in economic and financial activity. Moreover, it is necessary to recognize the need for prompt policy action to stabilize economic and financial activity once a correction of economic and financial excesses takes place.

IV. The Bank's Conduct of Monetary Policy

I will now talk about the Bank's conduct of monetary policy. The Bank releases the "understanding of medium- to long-term price stability," the level of inflation that each Policy Board member understands, when conducting monetary policy, as being consistent with price stability over the medium to long term, which I will refer to hereafter as "understanding." The "understanding" reviewed in April 2008, expressed in terms of the year-on-year rate of change in the CPI, falls in a range approximately between 0 and 2 percent. Taking account of the "understanding," the Bank assesses the economic and price situation from "two perspectives" and then outlines its thinking on the future conduct of monetary policy. Discussions based on these points are described in the semiannual Outlook for Economic Activity and Prices, or the Outlook Report. Developments in economic activity and prices for the month after the release of the April Outlook Report are in line with the projection in it. Let me now elaborate on the Bank's conduct of monetary policy based on the Outlook Report.

A. Assessing the Economic and Price Situation from the "Two Perspectives"

The first perspective involves assessing the most likely outlook for economic activity and prices in the next two fiscal years: the Bank assesses whether Japan's economy is likely to realize sustainable growth with price stability. It is expected that the growth rate of Japan's economy will decelerate for the time being, but that over the projection period as a whole it will likely grow at a pace around its potential growth rate. The year-on-year rate of change in the CPI (excluding fresh food) is likely to remain at around 1.0 percent on average. Such developments can be regarded as broadly in line with the "understanding."

The second perspective extends the time horizon and assesses the risks considered most relevant to the conduct of monetary policy, taking account of the cost incurred should risks materialize, even though the probability of such materialization may be low. Risks that demand most attention are the 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. Meanwhile, the outlook for prices is subject to upside risks stemming mainly from further increases in energy and materials prices; nevertheless, the possibility of the inflation rate deviating significantly from the "understanding" is small. In the long run, however, there remains the risk of possible swings in economic activity and prices if the period of accommodative financial conditions is further prolonged. The significance of this risk will increase if the downside risks I just mentioned should turn out to decrease.

B. Risk Balance Charts: A New Communication Tool at a Time of Increased Uncertainty about the Economic Outlook

Forecasts of economic activity and prices are always subject to considerable uncertainty, and currently the degree of uncertainty is especially high. In light of this situation, the Bank has decided to release, in addition to the forecasts of the majority of Policy Board members, Risk Balance 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 forecasts. The probability distribution for the rate of real GDP growth in fiscal 2008 is skewed to the downside. This suggests that Policy Board members consider the downside risks to be greater than the upside risks. On the other hand, the probability distribution for fiscal 2009 is more or less evenly balanced. Comparison of the probability distributions for fiscal 2008 and 2009 points to greater uncertainty ahead, since the distribution is flatter for fiscal 2009 than for 2008.

The probability distributions for the year-on-year rate of change in the CPI (excluding fresh food) for fiscal 2008 and 2009 are both somewhat skewed to the downside. The distribution is flatter for fiscal 2009 than for fiscal 2008, suggesting greater uncertainty as to the outlook for fiscal 2009.

C. The Future Conduct of Monetary Policy

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. I believe that the Bank should continue to gather as much information as possible, including information on developments in overseas economies, particularly the U.S. and European economies, global financial markets, and energy and materials prices, and, based on this, have a clear view of what may occur, but at the same time examine economic and price developments without having any predetermined view. The Bank will continue to make policy decisions appropriately from a comprehensive viewpoint, while communicating smoothly with the market.

Conclusion

Yamagata Prefecture has produced three out of the total of 30 Bank of Japan Governors: the 14th Governor, Seihin Ikeda; the 15th Governor, Toyotaro Yuki; and the 21st Governor, Makoto Usami. Mr. Ikeda, who became the Governor in 1937 after holding the de facto top executive position at a private bank, conducted a series of management reforms at the Bank of Japan in quick succession during a period of five months before resigning from office due to illness. I had a chance to read his biography and was truly and deeply moved by the mettle Mr. Ikeda had shown. Advocating pacifism at the time of World War II, he was urged by the then Prime Minister to recant his views in exchange for a reduction in military service assigned to his son, but he spurned such wheeling and dealing. With this opportunity of delivering a speech in his birthplace, I would like to reiterate that I greatly esteem this great predecessor at the Bank for his mettle, high ideals, and remarkable performance, and I will follow suit and perform my duty for all I am worth.

The Bank of Japan

Recent Economic and Financial Developments in Japan

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