Japan's Lost Decade : Policies for Economic Revival [1 ed.] 9781463993993, 9781589061873

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JAPAN’S LOST DECADE

Copyright © 2003. International Monetary Fund. All rights reserved.

Policies for Economic Revival

Editors

Tim Callen and Jonathan D. Ostry I N T E R N A T I O N A L

M O N E T A R Y

Japan's Lost Decade : Policies for Economic Revival, International Monetary Fund, 2003. ProQuest Ebook Central,

F U N D

JAPAN’S LOST DECADE Policies for Economic Revival

Copyright © 2003. International Monetary Fund. All rights reserved.

Editors

Tim Callen and Jonathan D. Ostry

I N T E R N AT I O N A L

M O N E TA RY

F U N D

Japan's Lost Decade : Policies for Economic Revival, International Monetary Fund, 2003. ProQuest Ebook Central,

© 2003 International Monetary Fund Production: IMF Graphics Section Cover design and figures: Lai Oy Louie Cover photo: Michael S. Yamashita / Corbis Composition: Julio R. Prego

Cataloging-in-Publication Data Japan’s lost decade : policies for economic revival / editors, Tim Callen and Jonathan D. Ostry – [Washington, D.C. : International Monetary Fund, 2003].

p. cm.

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Includes bibliographical references. ISBN 1-589061. Japan – Economic policy – 1989 - 2. Fiscal policy – Japan. 3. Monetary policy – Japan. 4. Foreign exchange rates – Japan. 5. International Monetary Fund – Japan. I. Callen, Tim. II. Ostry, Jonathan David, 1962III. International Monetary Fund. HC462.J35 2003

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Japan's Lost Decade : Policies for Economic Revival, International Monetary Fund, 2003. ProQuest Ebook Central,

Contents Page Foreword Managing Director . . . . . . . . . . . . . . . . . . . . . . . . . . . . v Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii 1. Overview Tim Callen and Jonathan D. Ostry . . . . . . . . . . . . . . . . 1 I. ADDRESSING FINANCIAL SECTOR WEAKNESSES 2. Current Issues Facing the Financial Sector Tim Callen and Martin Mühleisen . . . . . . . . . . . . . . . . 17 3. Banks and Credit in Japan Giovanni Dell’Ariccia . . . . . . . . . . . . . . . . . . . . . . . . 43 II. CORPORATE RESTRUCTURING AND STRUCTURAL REFORMS 4. The Resolution and Collection Corporation and the Market for Distressed Debt in Japan Kenneth Kang . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 5. Structural Reforms, Information Technology, and Medium-Term Growth Prospects Tim Callen and Takashi Nagaoka . . . . . . . . . . . . . . . . 80

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III. FISCAL POLICY CHALLENGES 6. Population Aging: Its Fiscal and Macroeconomic Implications Hamid Faruqee . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 7. Fiscal Policies During the Demographic Transition Martin Mühleisen . . . . . . . . . . . . . . . . . . . . . . . . . 136 8. Fiscal Policy: An Evaluation of Its Effectiveness Sanjay Kalra . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164 IV. MONETARY AND EXCHANGE RATE POLICY IN JAPAN 9. The Zero-Interest-Rate Floor and Its Implications for Monetary Policy in Japan Ben Hunt and Douglas Laxton . . . . . . . . . . . . . . . . . 179 10. Monetary Policy in a Deflationary Environment Taimur Baig . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206

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iv  CONTENTS

11. The Yen-Dollar Rate: Have Interventions Mattered? Ramana Ramaswamy and Hossein Samiei . . . . . . . . . 224 V. JAPAN AND ASIA

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12. The Impact of Japanese Economic Policies on the Asia Region Tim Callen and Warwick J. McKibbin . . . . . . . . . . . . . 251

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Foreword

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I

t is now 13 years since the bursting of the asset price bubble in Japan, yet the economy remains weighed down by excess capacity and debt and caught up in a prolonged slump. At the time of writing a moderate recovery from the 2001 recession—the third and deepest of the past decade—appears under way, although it is heavily reliant on external demand. At this juncture, economic policies must underpin a strengthening in private domestic demand to ensure that the rebound is translated into sustained economic growth over the medium term. Japan’s weak economic performance over the past decade has had implications not only for its own people, but for the world economy more generally, given Japan’s importance as a trading partner and supplier of capital. Rapid economic growth in the United States has served the global economy well, but has also contributed to rising global imbalances. While currency movements so far have been orderly, the possibility of a sudden adjustment cannot be ruled out. It will therefore be essential that in the period ahead global growth becomes more balanced. As part of this process, Japan needs to unlock its growth potential. The International Monetary Fund (IMF) has been involved in an intensive dialogue with the Japanese authorities to identify the policies needed to bring Japan’s economy out of its decade-long slump. In these discussions, the IMF has emphasized that restoring Japan’s growth performance to its demonstrated potential will necessitate an integrated policy strategy based on the decisive restructuring of the banking and corporate sectors, combined with macroeconomic policies designed to bring an end to deflation. Prime Minister Koizumi and his government deserve strong support for their commitment to carry through such reforms to restore confidence in the Japanese economy and foster sustained growth and job creation. I hope that the papers contained in this book can make a meaningful contribution to the ongoing debate about the policies needed to achieve this important goal. Horst Köhler Managing Director International Monetary Fund

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Acknowledgments

T

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he authors would like to acknowledge the valuable comments provided on earlier versions of the papers presented in this book by many colleagues at the IMF—particularly Yusuke Horiguchi and Charles Collyns—and by the Japanese authorities. Anita Jupp provided invaluable organizational and secretarial support, and Fritz Pierre-Louis excellent research assistance. The authors would also like to thank Marina Primorac, who edited the book for publication and coordinated production. The views expressed here, as well as any errors, are the sole responsibility of the authors, and do not necessarily reflect the opinions of the Japanese authorities, the Executive Directors of the IMF, or other members of the IMF staff.

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1 Overview

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J

apan’s economic performance since the early 1990s has been disappointing, both in relation to its own history and relative to the record of other major industrial countries. Real GDP growth has averaged 1 percent a year over the past 10 years, well below that in other OECD countries, and only one-fourth of the 4 percent annual average growth rate recorded in Japan in the 1980s. Japan, moreover, experienced three recessions in the past decade, in contrast to the trend in other industrial countries toward milder and less frequent downturns in the postwar period. Meanwhile, nominal GDP has fared even worse than real GDP (the level of nominal GDP in 2001 was approximately the same as in 1995), as moderate deflation has become entrenched. This poor economic performance has led some commentators to call the 1990s Japan’s “lost decade.” It is now generally recognized that Japan’s economic problems reflect a failure to deal proactively with the impact of the collapse in asset prices in the early 1990s. The bubble in Japanese stock prices burst in 1990 and, by mid-1992, equity prices had fallen by about 60 percent. Land prices began their downward spiral a year after stock prices and, while initially less precipitous than the drop in equity prices, the decline continued inexorably through the 1990s and early 2000s. The asset price collapse created problems for the banking system by impairing loan collateral and eroding bank capital—initially by wiping out hidden gains on stock holdings and subsequently through a direct feed through to banks’ capital ratios under the new marking-to-market rules. Firms—which had borrowed heavily to finance expansive business strategies in the bubble years—found themselves with massive excess debt and capacity in the face of the ensuing economic slowdown. While the growth slowdown was initially viewed as a cyclical response to the decline in asset prices, the long period of weak growth has led to a number of competing hypotheses to explain the poor performance. Research at the International Monetary Fund (IMF)—see, for 1

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OVERVIEW

example, the papers in Bayoumi and Collyns, 2000—has highlighted the central role played by financial institutions in magnifying the impact of the decline in asset prices on the economy. Increases in bank lending, operating both directly and through a self-reinforcing cycle with increases in land and stock prices, helped explain the strong growth in the second half of the 1980s. But, once asset prices began to fall, this process operated in reverse as undercapitalized banks restrained lending to maintain capital adequacy standards. In turn, this blunted the impact of macroeconomic policies as households and firms were unable to respond to monetary and fiscal stimulus because of the limited availability of funds from the banking system. Hayashi and Prescott (2002), by contrast, argue that the problem was a sharp fall in productivity stemming from the increasing failure of the traditional Japanese economic model to adapt to the requirements of a more deregulated and competitive world economy. Krugman (1998) takes yet a third view, according to which an insufficiency of demand drove the downturn, as Japan entered a liquidity trap—with nominal interest rates unable to fall below zero, and real interest rates too high to stimulate economic activity. The above hypotheses are not, of course, mutually exclusive, and indeed the prolonged period of lackluster performance may owe much to counterproductive interactions among the various forces, which magnified the downturn. For example, there is little doubt that dysfunctionality in the banking system—because of a shortage of capital in the face of still-to-be-recognized downgrades to asset quality—hampered the ability of monetary policy to end deflation. It is also likely that fiscal policy management—especially the focus on rural public works projects with low multiplier effects—undercut that instrument’s ability to support aggregate demand. Uneven progress in regulatory reforms has also contributed to a documented lack of productivity growth in many of Japan’s domestic sectors, in contrast to the more dynamic exportoriented industries such as electronics. This has resulted in a sharp slowdown in potential growth in the 1990s, helping to contain the size of the output gap, unemployment, and capacity underutilization over the past decade. At the time of writing this overview in late 2002, Japan appears to have emerged from its worst recession in postwar history. After three consecutive quarters of negative growth in 2001, activity picked up in early 2002, led by net exports as the United States and Asian economies rebounded. But private domestic demand has remained stubbornly weak, as the underpinnings of business investment and household spending continue to be plagued by excess stocks of debt,

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Overview

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capital, and labor, as well as by ongoing uncertainties about the soundness of the banking and fiscal systems. Despite the modest recovery, capacity utilization rates in manufacturing are low, while the IMF staff’s production function–based estimate of the output gap remains stuck around 3 percent of (potential) GDP despite a significant slowdown in the potential growth rate. Labor market adjustment continues, with firms scaling down jobs and the unemployment rate near record levels. And, particularly pernicious given the extent of corporate and public debt burdens, deflation persists at about 1 percent a year, with surveys suggesting this is likely to continue for some time to come. Financial markets also appear less than sanguine that a durable recovery is finally under way. Equity prices remain stuck at post-bubble lows, with bank stocks continuing to weigh heavily on the market. In addition to the weakness in the earnings outlook, structural factors— including the continued unwinding of cross-shareholdings between banks and corporates—have also had an impact on the market. The yen, however, has strengthened considerably since early 2002, although this likely reflects the strengthening of the balance of payments in the export-led phase of the recovery, rather than the market’s assessment that a durable economic turnaround is under way. Yields on Japanese government bonds (JGBs), meanwhile, have declined to 1 percent, despite sovereign rating downgrades and mounting public debt, consistent with the view that a pickup in nominal growth is some way off. More than a decade after the bursting of the asset price bubble, there remains pervasive evidence of unaddressed weaknesses in the banking and corporate sectors. Despite write-offs of 16 percent of GDP over the past decade, banks’ nonperforming loans (NPLs) have risen, and there is a likelihood that more loans will turn sour in the future. Weak profitability, meanwhile, continues to constrain banks’ provisioning capacity. While measured capital ratios remain above the minima mandated by the regulatory authorities, the weight of government preferred shares and deferred tax assets undermines capital quality. As well as the domestic implications, bank weaknesses also have potential ramifications for international financial stability given banks’ foreign securities holdings and lending and foreign investors’ exposure to Japan. On the corporate side, rates of return remain low, not least because of the slow progress in reducing the still significant excesses of capital, debt, and employment from the bubble years (Figures 1.1 and 1.2). Concerns about the impact of restructuring on unemployment may constrain the speed of adjustment—for example, the recourse to the Industrial Revitalization Law in some recent high-profile cases may reflect a desire to limit job losses relative to what would ensue under a court-led restructuring plan.

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OVERVIEW

Figure 1.1. Corporate Survey: Three ”Excesses” (Percent) 13

90 Debt/sales (right scale)

80 12

70 60

11 50

Labor costs/sales (left scale)

40

Fixed assets/sales (right scale)

10

30 9

1985 86

87

88

89

90

91

92

93

94

95

96

97

98

99 2000 01 02

20

Sources: Ministry of Finance; and IMF staff calculations.

The government of Prime Minister Koizumi, which came into office in April 2001, has made some progress in addressing the fundamental weaknesses in the economy. A strategy has been set out, encompassing banking reform, fiscal consolidation, and deregulation, but it is not fully fleshed out, and implementation has been slower and less complete than hoped and undermined by resistance from vested interests. The Figure 1.2. Corporate Survey: Return on Assets Copyright © 2003. International Monetary Fund. All rights reserved.

(Percent) 8

7

6

5

4

3

1985 86

87

88

89

90

91

92

93

94

95

96

97

98

99 2000 01 02

Sources: Ministry of Finance; and IMF staff calculations.

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Overview

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banking strategy is appropriately focused on strengthening loan classification practices, accelerating the disposal of NPLs, and reducing exposure to equity price risk. While some progress has been made on the first issue—including through the special bank inspections concluded in April 2002—there remain concerns that the true scale of the NPL problem has yet to be recognized, partly because the special inspections focused primarily on major banks’ exposure to large corporate borrowers, and thus ignored exposures to potentially weak small and mediumsized enterprises and of nonmajor banks. The authorities’ strategy on bad loan disposal is focused too narrowly, with specific time-bound requirements set only for the worst of major banks’ bad loans, rather than all NPLs across the entire banking system. Against this background, the IMF staff has been engaged in an intensive dialogue with the Japanese authorities to flesh out an integrated policy strategy to lift Japan’s economy from its decade-long period of lackluster performance and set the stage for self-sustained growth without deflation. The essence of the strategy is to move forward forcefully with bank and corporate restructuring in the context of supportive macroeconomic policies designed to limit any short-term adverse impact on economic activity and reverse the course of deflation. The staff’s strategy has four interlinked pillars, dealing respectively with banking reforms, corporate restructuring, fiscal policy, and monetary policy. With regard to the financial sector, the staff has stressed the need to adopt a more forward-looking approach to loan classification and provisioning practices systemwide to ensure that loans are realistically valued on bank balance sheets. A key issue relates to “gray-zone” loans—loans that are performing (in no small measure because nearzero interest rates allow firms with barely positive cash flow to remain current on debt service) but are at clear risk of becoming nonperforming. Absent regulatory pressure or a strong capital base, banks lack incentives to be aggressive with such claims, especially if they expect higher recovery values down the road. If such a comprehensive review of classification and provisioning practices were to result in bank capital ratios falling below regulatory minima, as many observers expect, and if banks continue to face difficulty in raising private funds, there would be no alternative in the staff’s view but to inject public capital into systemically important banks, subject to strong conditionality to limit moral hazard. An alternative approach—spreading recognition of nonperforming loans over a number of years to allow provisions to be paid from operating profits with no impact on capital—would preserve an aura of stability, but would postpone resolution of the fundamental problems. For nonsystemic banks that fail to meet capital requirements,

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OVERVIEW

“prompt corrective action” would need to be invoked, including orderly exit of nonviable banks. Together with a scaled-down role of public financial intermediation achieved by leveling the playing field with private banks, this would underpin efforts to boost banks’ core profitability over the medium term. On corporate restructuring, the lack of progress by banks in pushing through strong restructuring at debtor firms needs to be overcome. Given that the bulk of firms’ excess leverage is owed to banks, it is the banks that must take the lead in agreeing restructuring plans with their potentially viable debtors, pushing nonviable firms into liquidation, and disposing of unwanted loans to third parties—such as the Resolution and Collection Corporation (RCC), the soon-to-be-created Industrial Revitalization Corporation (ICC), or private investors. The RCC and ICC have a key role to play in developing Japan’s distressed debt market, not least by accelerating purchases and rapid resales of NPLs, including “gray-zone” loans, where the bulk of companies with a real chance of a turnaround are likely to be found. A range of structural reforms are also needed to ease the transitional costs from corporate restructuring and generate new investment and job opportunities, including steps to improve labor mobility and enhance the social safety net; regulatory reforms in critical sectors (such as health and child care, retail and distribution, and housing); proactive enforcement of competition policy; and strengthening of corporate governance rules. Given the high level of public sector debt and the large budget deficit, the staff has stressed the need to lay out a detailed and credible medium-term fiscal consolidation strategy to maintain investor confidence in JGBs. At the same time, however, steps would be needed to ensure that a sizable near-term fiscal contraction did not add headwinds to economic activity that would arise from an accelerated effort to spur bank and corporate restructuring. Key fiscal reforms that would help to establish the credibility of the government’s program include: • spending reform, especially the elimination of the current practice of earmarking revenues for road-related spending projects, and a more thorough cost-benefit analysis of public works projects to free up resources for an expanded social safety net and bettercrafted job training programs; • tax reform, including broadening of the personal and corporate income tax bases, perhaps with cuts in effective corporate tax rates (early introduction of taxpayer identification numbers would facilitate such base broadening); • social security reform, including curbs in the health care system’s total outlays and another round of old age pension reforms; and

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• faster progress on restructuring and privatizing public enterprises, including government financial institutions. In addition to the need to make early progress on implementing these reforms, the IMF has also stressed the need for the government to publicly lay out a comprehensive strategy to stabilize the public debt ratio over a 5–10 year horizon and to subsequently bring the debt ratio down, given the looming demographic pressures. A permanent fiscal responsibility law could provide an appropriate vehicle to set out a medium-term debt target and the broad objectives of tax, spending, and social security policies. On monetary policy, there is a broad consensus—including in the Bank of Japan itself—that the policy actions taken to date are unlikely to produce an early end to deflation. A range of research nevertheless suggests that there is scope to do more on the monetary policy front, even though short-term interest rates are at their floor. Deflationary episodes in Sweden and the United States in the 1930s are at least suggestive that more aggressive and sustained actions than have yet been undertaken by the Bank of Japan could be helpful in ridding Japan of entrenched deflation. While bank weaknesses are clearly undercutting the effectiveness of monetary policy, the monetary transmission mechanism—including through the portfolio-rebalancing and expectations channels—does not appear to have been fully short-circuited. IMF staff have thus stressed the need for the Bank of Japan to publicly commit to end deflation within a reasonable (12–18-month) time frame, backed up by further quantitative easing, including accelerated purchases of JGBs. This should be followed over the medium term with a positive inflation target to help guard against the risk of again being constrained by the zero bound on nominal interest rates. Movements in the yen have been a source of concern for countries in the Asian region, particularly for those that fix their currencies to the U.S. dollar. While the exchange rate may constitute one potential transmission channel of monetary policy at this stage, the IMF staff’s view has been that concerns about the potential regional impact should not impede the implementation of a vigorous monetary policy aimed at delivering a timely end to deflation. The impact of movements in the yen are likely to be more manageable now than during the Asian crisis, given the generally greater flexibility of exchange rate regimes, stronger reserve positions, and healthier external debt profiles in the region. Indeed, were monetary easing to take place in the context of a comprehensive policy package to restore healthy growth in Japan, any weakening of the yen might be limited by an increase in confidence about Japan’s future economic prospects. Such a policy package would

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be of substantial benefit to the Asian region—and the rest of the world—over the medium term. The papers presented in this book flesh out the details of the four interlinked pillars of the IMF staff’s proposed policy strategy. The first two sections of the book address the core issues of bank and corporate restructuring. Section I, “Addressing Financial Sector Weaknesses,” deals with issues relating to the reform of the financial sector, while Section II, “Corporate Restructuring and Structural Reforms,” examines the policies needed to accelerate restructuring in the corporate sector, and the implementation of structural reforms to help generate employment and investment opportunities in new sectors of the economy. The third and fourth sections of the book discuss issues related to macroeconomic policies. In Section III, “Fiscal Policy Challenges,” the sustainability of public debt position and the effectiveness of fiscal policy as a demand management tool are taken up. Section IV, “Monetary and Exchange Rate Policy in Japan,” discusses the conduct of monetary policy in a deflationary environment. Because of Japan’s importance in the Asia region, Section V of the book, “Japan and Asia,” looks at the impact of reforms in Japan on other Asian countries. In Chapter 2, “Current Issues Facing the Financial Sector,” Tim Callen and Martin Mühleisen provide an overview of recent developments in the banking and life insurance sectors. In light of the sharp economic slowdown in 2001 and the steep drop in equity prices, questions have once again been raised about the financial health of these institutions. In response, the authorities have set out a reform strategy to deal with the weaknesses in the banking sector, but the chapter assesses that much more needs to be done. In particular, despite steps to strengthen loan classification practices—including through the recently concluded special bank inspections—considerable doubt remains about whether the authorities have recognized the true scale of the NPL problem. Given the scheduled removal of the blanket guarantee on most demand deposits from end-March 2005, time is of the essence in dealing with these issues. If doubts remain then about the health of the banks, there is the potential for deposit shifting between institutions, and the risk that contagion could spread from weak institutions. Over the medium term, boosting underlying profitability is the key to ensuring a healthy banking system. Consequently, the authors discuss measures to raise bank profitability, including reforms to downsize the postal savings system and government financial institutions. The issue of how the quality of bank loan portfolios and the degree of corporate indebtedness have affected the evolution of bank credit in Japan is examined by Giovanni Dell’Ariccia in Chapter 3, “Banks and

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Credit in Japan.” An important policy question is whether the recent contraction in bank credit stems from weaknesses in the banking system, which has led to a decline in the supply of credit, or from a lack of corporate demand for credit as companies reduce their excess leverage. To investigate this issue, a three-dimensional panel of data is used, disaggregated by firm size, industrial sector of the borrowing firm, and specialization of the lending bank. The results of the analysis suggest that both corporate and banking sector weaknesses share the blame for the decline in bank credit. On the banking side, credit growth is found to be lower for banks with a high initial proportion of nonperforming loans and a low initial loan-loss reserve ratio, while on the corporate side, a high initial degree of bank dependence and leverage are found to be detrimental to credit growth. The policy implications of these results are that the resolution of balance sheet problems in both the banking and corporate sectors is necessary to restore healthy credit growth in Japan. The role of the RCC in the corporate restructuring process is examined in detail in Chapter 4, “The Resolution and Collection Corporation and the Market for Distressed Debt in Japan,” by Kenneth Kang. The chapter outlines the current operations of the RCC, and how it is supporting the government’s objective of accelerating the removal of NPLs from bank balance sheets. Drawing on other countries’ experiences with asset management companies, the chapter examines the role the RCC should assume in the corporate restructuring process in Japan, and outlines recommendations on how the RCC can play a more effective role in transferring NPLs from banks to the private sector and help to strengthen the existing market for distressed debt. In Chapter 5, “Structural Reforms, Information Technology, and Medium-Term Growth Prospects,” Tim Callen and Takashi Nagaoka examine Japan’s productivity performance during the 1990s. As productivity levels in many domestic sectors of the economy are well below international best standards, there appears to be considerable scope for raising productivity and growth in Japan over the medium term. Indeed, empirical studies have estimated that considerable benefits—anywhere from 2!/4 percent to 18#/4 percent of GDP—could accrue over the medium term from implementing a comprehensive reform program. The chapter highlights four particularly important areas—the labor market; entrepreneurship; the regulatory structure and competition policy; and the information technology (IT) sector—and assesses the reforms that have been implemented to date and what more needs to be done. The first chapter of the fiscal policy section of the book is “Population Aging: Its Fiscal and Macroeconomic Implications” by Hamid

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Faruqee. Demographic changes—a rapidly aging and shrinking population—will be a prominent feature of the Japanese economic landscape in the coming years, and will have important implications for economic and fiscal developments. In this chapter, demographic dynamics and the social security system are incorporated into MULTIMOD—the IMF’s multicountry macroeconomic model—and simulations conducted to examine the economic implications of population aging in Japan, as well as the policies designed to address it. The results suggest that demographic changes will likely result in slower output growth over the next half century (relative to the case of no demographic change), although saving rates and the current account ratio need not decline significantly. In terms of policy implications, the analysis highlights the importance of taking into account prospective changes in the macroeconomic environment when evaluating policies that address the challenges posed by population aging, as well as the impact of reforms on private sector behavior. For example, the simulations suggest that reforms to social security benefits could have a large effect on private saving as agents anticipate having to finance more of their own consumption in retirement. In Chapter 7, “Fiscal Policies During the Demographic Transition,” Martin Mühleisen examines the policies that could help restore fiscal sustainability in Japan in the face of the ongoing unfavorable demographic trends. Building on the model developed in Chapter 6, detailed simulations of the fiscal accounts in Japan are used to address a number of issues: (1) the degree of fiscal adjustment needed to stabilize public debt over the medium term; (2) the output costs of alternative fiscal strategies to achieve that target; (3) the implications of demographic developments for public finances under the present policy framework; and (4) reforms that would safeguard the viability of the social security system while mitigating the impact on economic growth. The simulation results suggest that strong policy adjustments will be needed to put Japan’s public finances back on a sustainable footing. Cuts in public investment, base-broadening measures for income taxes, some increase in the consumption tax, and reductions in social security benefits are likely to be the key building blocks of a solution to the difficult fiscal situation. The issue of the effectiveness of fiscal policy as a demand management tool is taken up by Sanjay Kalra in Chapter 8, “Fiscal Policy: An Evaluation of Its Effectiveness.” The persistence of slow growth in Japan since the early 1990s despite rising structural budget deficits has led some observers to question whether fiscal policy is able to provide even a short-term stimulus to economic activity in Japan in present cir-

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cumstances. In this chapter, structural vector autoregressions are used to derive dynamic fiscal multipliers for government revenues and expenditures to assess the impact of budgetary policies on economic activity. The results suggest that fiscal policy still has a role as a countercyclical demand management tool. Short-run fiscal multipliers are positive, and actually do not appear to have changed much over time. Fiscal multipliers at longer time horizons, however, are found to have declined significantly, and the chapter argues that this is likely due to changes in the composition of government spending, which has reduced the economic impact of such expenditures. Specifically, public investment has increasingly been focused on expanding social infrastructure and capacity—mostly related to agriculture and rural road construction—which have little flow-on effect to private activity, while government consumption has become more concentrated on health care and less on the provision of economic services. In Chapter 9, “ The Zero-Interest-Rate Floor and Its Implications for Monetary Policy in Japan,” Ben Hunt and Doug Laxton use the Japan block of MULTIMOD to investigate the implications of the zero bound on nominal interest rates for the design of monetary policy, and the effectiveness of different policy interventions to stimulate the economy when short-term nominal interest rates are at their floor. The results of the simulations presented in the chapter suggest that the Bank of Japan should commit to achieving a target rate of inflation above 2 percent to significantly reduce the probability that the zero bound on nominal interest rates will again become binding, and that macroeconomic performance will consequently suffer. In terms of the different policy responses considered, one-off fiscal and monetary policy interventions are both found to be effective in stimulating the economy even when the zero bound is binding. However, a monetary policy response— through a credible commitment to future inflation—results in a better outcome for the government debt-to-GDP ratio. The impact of quantitative monetary easing on activity and prices is taken up by Taimur Baig in Chapter 10, “Monetary Policy in a Deflationary Environment.” The chapter first looks at deflationary episodes in Sweden and the United States in the 1930s, and argues that these episodes suggest more aggressive and sustained quantitative easing than has so far been undertaken by the Bank of Japan could be helpful in ending deflation. It then uses reduced-form vector autoregressions (VARs) to examine the monetary policy transmission mechanism in Japan when nominal short-term interest rates are at their floor. The results from the VARs indicate a potentially favorable impact of quantitative easing on demand and prices through the asset price or portfolio

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12



OVERVIEW

rebalancing channel. Moreover, the results suggest that, while banking sector weaknesses dampen the effectiveness of monetary policy, they do not completely short-circuit the transmission between base money and other economic variables. The authorities’ heavy intervention in the foreign exchange market to counter the sharp appreciation of the yen during May and June 2002 has again raised questions about the effectiveness of sterilized foreign exchange intervention. This issue is taken up in Chapter 11, “The YenDollar Rate: Have Interventions Mattered?” by Ramana Ramaswamy and Hossein Samiei. An interest rate arbitrage rational expectations model of the exchange rate and a probit model of the probability of interventions are estimated to assess the effectiveness of intervention in the yen-dollar market since the mid-1990s. The results indicate that interventions—even though they are routinely sterilized—have on the whole mattered, and have succeeded on a number of occasions in changing the path of the yen-dollar rate in the desired direction. The chapter argues that this relative success—which is contrary to conventional wisdom—is because interventions influence market participants’ expectations of future economic fundamentals and the stance of monetary policy, and erode bandwagon effects in the foreign exchange market. The estimation results also indicate that coordinated interventions are more effective than unilateral ones—and, when successful, have a much larger effect on the exchange rate—while unilateral interventions to weaken the yen have had a lower success rate than unilateral interventions to strengthen the currency. This latter finding is important in the context of the authorities’ recent interventions to weaken the yen. The final chapter of the book, “The Impact of Japanese Economic Policies on the Asia Region,” by Tim Callen and Warwick McKibbin, examines the trade and financial links between Japan and its regional neighbors, and how these have changed over time. It then uses the Gcubed (Asia-Pacific) model—a macroeconomic model with rich crosscountry links—to explore the implications of a number of policies and developments in Japan for the domestic and regional economies. The simulation results suggest that: • reforms that boost productivity growth in Japan would be very beneficial for both the domestic and regional economies; • while fiscal consolidation in Japan would initially dampen domestic growth, over the medium term the impact on both the domestic and regional economies would be positive; and • quantitative monetary easing in Japan would boost domestic activity in the short run, while being basically neutral for the region.

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Overview

 13

Taken together, the papers in this book aim to provide a comprehensive assessment of the current economic situation in Japan, and the policies needed to reverse the economy’s long slump. The overall message is that while the Japanese authorities have made an important start in implementing the necessary reforms, much more needs to be done to secure a return to self-sustained growth. Moreover, such a return is urgently needed, not only for Japan’s own prosperity, but also to enable Japan to once again play an economic leadership role in Asia and in the global economy.

References Bayoumi, Tamim, and Charles Collyns, 2000, Post-Bubble Blues: How Japan Responded to Asset Price Collapse (Washington: International Monetary Fund). Hayashi, Fumio, and Edward C. Prescott, 2002, “The 1990s in Japan: A Lost Decade,” Review of Economic Dynamics, Vol. 5 (Special issue, January).

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Krugman, Paul, 1998, “It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap,” Brookings Papers on Economic Activity: 2 (Washington: Brookings Institution), pp. 137–205.

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I

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ADDRESSING FINANCIAL SECTOR WEAKNESSES

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2 Current Issues Facing the Financial Sector TIM CALLEN AND MARTIN MÜHLEISEN

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T

he Japanese financial system remains a source of concern. The sharp slowdown in the economy in 2001—which pushed bankruptcies to their highest level since 1984—and the steep drop in equity prices once again raised questions about the financial health of Japanese banks and life insurance companies. The authorities have responded to the long-term weaknesses in the banking sector by setting out a three-pronged strategy for restoring their financial health, based on (1) strengthening classification and provisioning standards to ensure that loans are realistically valued on balance sheets; (2) removing nonperforming loans (NPLs) from balance sheets within a 2–3 year time frame; and (3) reducing exposure to equity price risk. Together with the withdrawal of the deposit insurance guarantee for large time deposits from April 1, 2002, these measures represent important steps toward restoring confidence in the banking sector. Continued progress, however, will be required if the removal of the full guarantee on most demand deposits—now scheduled for end-March 2005 after having been delayed by two years from the previous deadline—is to proceed smoothly. In the life insurance sector, declining equity prices and negative yield spreads have adversely affected financial strength, but further bankruptcies so far have been avoided. Given their holdings of foreign securities and lending overseas—particularly in Asia—the continued stability of the Japanese banking and life insurance sectors are important not only for the domestic economy, but also for international markets. 17

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18

TIM CALLEN AND MARTIN MÜHLEISEN

Bank Balance Sheets and Financial Performance Banks continue to be adversely affected by the weak ongoing economic environment and the fallout from decisions made in the bubble years. Credit costs related to nonperforming loans and the declining value of their equity portfolios have resulted in banks making large losses in recent years, and bank capital has come under increasing pressure. This section assesses the recent financial performance of banks and developments in their balance sheets. Major Banks Following two years of modest profits, major banks experienced aggregate losses of ¥3.5 trillion in FY2001, similar in magnitude to those in FY1997 and FY1998 (Figure 2.1). While operating profits increased by 20 percent to ¥4.1 trillion—largely due to increased earnings from treasury operations—this was overshadowed by a near doubling of credit costs and large losses on equity holdings. • Banks incurred ¥7.7 trillion of credit costs, nearly four times the level they had forecast at the start of the financial year. This was largely a consequence of the severe economic downturn and ongoing deflation during 2001, which led to a surge in bankruptcies and a further decline in collateral values, and the enforcement of Figure 2.1. Major Banks' Profits, FY1990–2001

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(Yen, trillions) 10

5

0

–5 Operating profits

–10

–15

Net equity capital gains Loan loss charges Net income FY1990 FY91

FY92

FY93

FY94

FY95

FY96

FY97

FY98

FY99 FY2000 FY01

Source: Fitch IBCA.

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Current Issues Facing the Financial Sector

 19

stricter loan classification standards by the Financial Services Agency (FSA), including through the special inspections (see below). To some extent, the revision also reflects the overly optimistic estimates of credit costs that banks tend to make at the beginning of the financial year. However, despite their loan write-offs in recent years, the major banks are still faced with a considerable stock of nonperforming loans (see below).1 • Equity price weakness also hurt bank performance. Despite progress in unwinding cross-shareholdings, banks still hold large equity portfolios. These holdings were marked-to-market for the first time in FY2001, which—given the weakness in the equity market during most of the year—resulted in losses of about ¥1.6 trillion (¥3 trillion including losses taken directly on the balance sheet).2 As a result of the losses, and reflecting their inability to raise significant additional private capital, regulatory capital ratios of the major banks declined during FY2001. At end-March 2002, the average (unconsolidated) capital adequacy ratio of the major banks was 10#/4 percent, down from 11#/4 percent a year earlier. The capital adequacy ratios ranged from 11!/2 percent to slightly above 10 percent for the internationally active banks—which have a minimum capital ratio requirement of 8 percent—and from about 10!/2 percent to slightly above 8 percent for those that are not internationally active (and have a minimum required capital ratio of 4 percent). The quality of major bank capital has deteriorated. Government preference shares and deferred tax assets now account for almost all of Tier-1 capital, while other Tier-1 capital (common equity, market-based preferred securities, and retained earnings) has been virtually eliminated (Table 2.1). 3 Reflecting concerns about their financial health, bank stocks have been under downward pressure for much of the past year. The TOPIX banking sub-index fell by 24 percent in the year to November 2002, compared with a 15 percent decline in the overall market over the same period. Yields on bank certificates of deposit (CDs) and spreads on bank bonds also increased during December 2001–March 2002, although 1Over the past decade, major and regional banks have incurred losses of about ¥82 trillion (16 percent of GDP) on their problem loans. 2The general rule for equity investments is to recognize valuation losses and post a write-down charge in the income statement when a stock’s market value falls 50 percent below cost. The difference between the market price and cost that is not taken through the income statement is, after adjustment for deferred tax, debited or credited to equity. 3Banks can only carry deferred tax assets on their balance sheets up to the limit of their expected taxable income over the next five years.

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TIM CALLEN AND MARTIN MÜHLEISEN

Table 2.1. Major Bank Capital (March 2002)

Deferred tax assets Minority interest Public funds (pref. stocks) Other Tier-1 capital Total Tier-1 capital Total capital Memorandum: Regional banks (Tier 1)2 Regional banks (Tier 2)2 Shinkin banks3 Credit cooperatives3

Yen, trillions

Percent1

8.4 2.7 6.0 0.4 17.5 33.7

2.6 0.9 1.8 0.1 5.4 10.4

11.5 2.9 5.9 0.8

9.9 8.0 10.0 7.9

Source: Financial Services Agency; Fitch IBCA. 1Of risk-weighted assets. Consolidated basis. 2As of September 2001. 3As of March 2001.

they have declined since (Figure 2.2). The Japan premium (the spread between U.S. dollar borrowing costs of Japanese banks and U.S. LIBOR), however, has not resurfaced—it reached 100 basis points in 1998—as Japanese banks have not been very active in this market. Banks have also raised their prime lending rate from 2 percent in April 2002 to about 1.5 percent in recent months.

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Regional Banks and Other Deposit-Taking Institutions The financial performance of large regional banks deteriorated during FY2001, although it was quite variable among institutions (Table 2.2). The weak economy, ongoing deflation, and declining stock prices all adversely affected the regional banks during FY2001. However, with their financial performance closely tied to economic developments in the region in which they are based, there was considerable disparity in financial performance. Some two-thirds managed to report small profits, although others saw sharp increases in their loan losses as a result of the deterioration in business conditions at large regional companies. Capital ratios (at end-September 2001) averaged 9.9 percent and 8 percent for Tier-1 and Tier-2 regional banks, respectively. Two regional banks filed for bankruptcy during FY2001.4 In light of the difficult position of the regional banks, the FSA has recently announced that it 4The Deposit Insurance Corporation has established a bridge bank—the Bridge Bank of Japan. The two failed regional banks, Ishikawa Bank and Chubu Bank, contracted with the bridge bank to transfer their operations on March 28, 2002, and buyers are currently being sought. The bridge bank may exist for a maximum of three years, after which the failed banks will be liquidated if no buyer has been found.

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Figure 2.2. Recent Banking Sector Indicators Basis points

100 80

Percent

Bond Spread and Three-month CDs CD Rates (right scale)

0.25 0.20

Basis points

0.12

Japan Premium2

0.10 0.08

60 Bond spread

0.15

0.06

40

0.10

0.04

20

0.05

(left scale)1

Three-month One-month

0.02

0

0

Apr. Jun. Aug. Oct. Dec. Feb. Apr. Jun. Aug. Oct. Dec.

2001

0 –0.02

Apr. Jun. Aug. Oct. Dec. Feb. Apr. Jun. Aug. Oct. Dec.

2001

2002

Percent

2002

Index (April 2, 2001=100)

120

3.0

Bank Prime Lending Rate 2.5 and Debentures

Stock Prices

100 2.0

TOPIX-Overall

80

1.5 Long-term prime 1.0

60 0.5

Banking sector

Five-year bank debentures

0

Apr. Jun. Aug. Oct. Dec. Feb. Apr. Jun. Aug. Oct. Dec.

2001

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Apr. Jun. Aug. Oct. Dec. Feb. Apr. Jun. Aug. Oct. Dec.

2001

10 Deposit Growth by Type of Bank 8 Tier-I 6 regonal banks 4 2 Total 0 City –2 banks –4 –6 –8 Tier-II regonal banks –10 2000

2001

2002

Twelve-month percent change

Twelve-month percent change

1999

40

2002

2002

40

Growth of Bank Deposits

20

Demand deposits

0 –20

Time deposits less than ¥10 million Time deposits greater than ¥10 million

–40

1999

2000

2001

2002

Sources: Bloomberg, LP; and WEPA, Nomura Database. 1Five-year Japanese bank bonds minus five-year government bond yields. 2Average U.S. dollar LIBOR of Fuji Bank, Bank of Tokyo, and Norinchukin bank minus the LIBOR fix.

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TIM CALLEN AND MARTIN MÜHLEISEN

Table 2.2. Regional Banks’ Financial Performance1 (Yen, billions)

Operating revenue Net interest income Fees and commissions Overhead costs Operating profit Credit costs Net equity gains (losses) Net income

FY00

FY01

1,263 1,083 141 746 517 558 102 36

1,265 1,070 150 740 525 705 –281 –355

Source: Fitch IBCA. 1Results reflect the performance of 10 large regional banks.

will consider measures to encourage these institutions to merge where appropriate.5 The FSA continued to address weaknesses among credit cooperatives and Shinkin banks during FY2001. Stepped-up inspections led to improved credit quality assessments and contributed to a further 55 of these institutions closing during the year. Including those that have announced bankruptcy, 226, or 30 percent of, credit cooperatives and Shinkin banks have closed over the past five years. These institutions, however, still suffer from a relatively high incidence of nonperforming loans and a weak capital base.

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The Nonperforming Loan Problem The weak economy and the strengthening of loan classification practices by the FSA has resulted in a further increase in NPLs during FY2001 (Table 2.3). For the major and regional banks combined, NPLs stood at ¥43.2 trillion (8!/2 percent of outstanding loans) at end-March 2002, up from ¥33.6 trillion (6!/4 percent of loans) at end-March 2001.6 NPLs of major and regional banks were 8.7 percent of loans and 8 percent of outstanding loans, respectively. Of the ¥9.6 trillion increase in NPLs during FY01, ¥5.6 trillion was due to an increase in “special mention” loans—those to which the bank needs to pay close attention because they are three months or more past due or have been restructured—and ¥4 trillion due to an increase in loans to bankrupt 5The recent announcement that Nishi-Nippon Bank and Fukuoka City Bank will form a holding company in April 2003 may be a sign of increasing merger activity. 6These data reflect the definition of NPLs according to the Financial Reconstruction Law, which includes claims on borrowers in or near bankruptcy and claims on borrowers requiring “special attention” (mainly those with restructured loans and loans past due by more than three months).

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Current Issues Facing the Financial Sector

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Table 2.3. Nonperforming Loans1 March March March March March March 2000 2001 2002 _____________________ 2000 2001 2002 ____________________ (Yen, trillions) (Percent of loans) Nonperforming loans (Financial Reconstruction Law standard) Deposit-taking institutions 42.2 Banks 31.8 Major banks 20.4 Regional banks 11.4 Cooperative-type financial institutions 10.4

43.0 33.6 20.0 13.6 9.4

52.4 43.2 28.4 14.8 9.2

6.6 5.9 5.8 6.2 9.9

6.8 6.3 5.7 7.3 9.7

8.6 8.4 8.7 8.0 9.7

Memorandum: Specific reserves Deposit-taking institutions 11.5 Banks 8.4 Major banks 5.0 Regional banks 3.4 Cooperative-type financial institutions 3.1

10.0 7.2 3.9 3.3 2.8

10.4 7.9 4.7 3.2 2.5

27.8 27.7 25.3 32.1 28.2

23.1 22.3 20.3 25.1 25.6

19.6 18.8 17.0 22.2 22.7

13.6

15.7

11.2

General reserves (major banks)

2.7

3.0

3.12

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Source: Financial Services Agency; Fitch IBCA; and IMF staff calculations. 1Data are not necessarily comparable between years, owing to the exclusion of nonperforming loans of bankrupt institutions. 2September 2001.

and near-bankrupt borrowers. While banks removed over ¥9 trillion of loans to bankrupt and near-bankrupt borrowers from their balance sheets during the year, over ¥13 trillion of loans were downgraded to these categories (because of both the special inspections and the deterioration in economic conditions). Against their NPLs, major and regional banks hold ¥7.9 trillion of specific reserves, as well as about ¥10 trillion of “superior” collateral;7 they also hold ¥4–5 trillion of general reserves. For deposit-taking institutions as a whole, NPLs stood at ¥52.4 trillion (8!/2 percent of outstanding loans) in March 2002, compared with ¥43 trillion (6!/2 percent of loans) in March 2001. A much larger volume of loans, however, may be at risk of becoming nonperforming. The total face value of classified loans of the major and regional banks—those to borrowers rated as “needing attention” and below—stood at ¥107.7 trillion (21 percent of outstanding loans) at end-September 2001 (latest available data). About ¥40 trillion of these loans are covered by “superior” collateral or guarantees, with most of 7Superior collateral includes deposits and other financial instruments (such as government bonds) of high quality that are easily disposable. Ordinary collateral includes other types of collateral (such as real estate).

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TIM CALLEN AND MARTIN MÜHLEISEN

the remainder covered by ordinary collateral. In the current deflationary environment, loans classified as “needing attention,” or even some “normal” loans, could, however, quickly deteriorate to nonperforming status. Even with an economic recovery, companies in certain sectors of the economy will remain under pressure. For example, the sharp rise in import penetration into Japanese clothing and low-end consumer goods markets—particularly from China—is likely to continue to affect companies in these sectors, while the government’s objective of reducing public works spending will hurt firms in the construction sector that have come to rely on these projects. Many market analysts continue to raise questions about loan classification and provisioning practices. Indeed, recently released data by the FSA also show a significant gap between its assessment of the size of the NPL problem and the banks’ own internal assessments. Analysts use a variety of approaches to estimate the potential amount of additional loan-loss charges needed for the major and regional banks to reach adequate provisioning levels (Box 2.1). These approaches have generally suggested a broad magnitude of uncovered loan losses at major and regional banks of ¥20–30 trillion (5–6 percent of GDP). The basis for this assessment is that (1) the average loan-loss rate on existing NPLs may be higher than the current rate of provisioning, including because the disposal of land collateral is likely to occur at depressed prices in the absence of a liquid real estate market; and (2) a substantial amount of “gray-zone” loans—those to borrowers requiring attention but that are not classified as nonperforming—are likely to become nonperforming and incur losses (given the current low level of interest rates, many weak companies are able to continuing paying interest on their loans until they are on the verge of bankruptcy). The estimate of uncovered loan losses has not changed significantly over the past year because analysts believe that the disposal of bad loans in the second half of FY2001 has been largely offset by the emergence of new NPLs. Such estimates of uncovered loan losses, however, remain sensitive to underlying assumptions, as illustrated in Table 2.4.

Reforms to Address Banking Sector Weaknesses Over the past two years, the government, in a number of policy packages—the most recent in October 2002—has laid out a strategy for dealing with the problems in the banking sector. This strategy consists of three key elements: strengthening efforts to dispose of NPLs; strengthening loan classification and provisioning practices; and reducing exposure to equity price risks.

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...

514.7 ...

...

100.0%

80.0%

10.0% 20.0%

1.0%

0.5%

0.0

12.1

0.0

2.1

5.5 2.1

0.4

2.0

...

...

100.0%

85.0%

17.5% 30.0%

2.0%

1.0%

7.7

19.8

0.0

2.2

9.6 3.2

0.8

4.1

...

...

100.0%

90.0%

25.0% 45.0%

3.0%

1.5%

16.0

28.1

0.0

2.3

13.7 4.8

1.2

6.1

...

...

100.0%

100.0%

35.0% 60.0%

4.0%

2.0%

25.7

37.8

0.0

2.6

19.1 6.4

1.6

8.1

Scenario I Scenario II Scenario III Scenario IV ___________________ ___________________ ___________________ ___________________ Loss ratio Loss Loss ratio Loss Loss ratio Loss Loss ratio Loss

Sources: Financial Services Agency; and IMF staff calculations. 1Collateral refers to both loan collateral and loan guarantees. 2Bankrupt borrowers include de facto bankrupt borrowers and borrowers in danger of bankruptcy. 3Banks are assumed to hold a combined ¥12.1 trillion in general and specific provisions.

Uncovered loan

losses3

0.0

Unrecoverable loans to bankrupt borrowers2

Total

2.6

54.7 10.6

Loans secured by ordinary collateral Borrowers requiring attention Bankrupt borrowers2

Loans to bankrupt borrowers with doubtful recovery value2

39.8

407.0

Loans to at-risk borrowers secured by superior collateral1

Normal loans

amount

Loan

(Based on September 2001 loan classification according to banks’ self-assessment; yen, trillions)

Table 2.4. Sensitivity Analysis for Uncovered Loan Losses of Major and Regional Banks

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TIM CALLEN AND MARTIN MÜHLEISEN

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Box 2.1. Methods to Estimate Bank Loan Losses In view of banks’ past loss experience, market analysts generally consider that current provisioning levels are inadequate to cover losses that might arise both from reported nonperforming loans (NPLs) and from loans to troubled borrowers that might become nonperforming in the near future. Analysts base their estimates on how much more provisioning will be needed on different methods, partly depending on the quality of loan data at their disposal. • One approach is to compare the ratio of bank loans to GDP at the height of the bubble with its long-term average, which gives a rough measure for the amount of excess loans that needs to be written off. Uncovered loan losses can be calculated by subtracting the cumulative amount of loan losses that has already been recognized. • Some analysts have applied assumed loss rates to the amount of outstanding nonperforming and “gray zone” loans. These rates are assumed to increase sharply from historical levels (which can be calculated from bank’s loan books), owing to a weakening economy, a concentration of loans in weak sectors, less room for evergreening, and a tougher approach by bank regulators. Analysts generally refer to the experience with nationalized banks, when inspectors discovered a much larger amount of NPLs than had been classified as such by the banks. • Another approach, which accounts for the fact that banks continue to experience losses on collateral as long as a loan has not been fully removed from the balance sheet (which may take several years), applies a common loss rate to all loans that have been reported to be nonperforming since the end of the bubble. Estimates for the loss rate can be based on the relatively few loans that have been resolved by loan disposal agencies (such as the CCPC, an institution that resolves credit cooperative loans), or on prices for bad loans on the secondary market. • Finally, one approach is to modify loss rates according to the year in which bank loans have been taken out. This also takes account of the fact that losses relate to the decline of collateral values over the lifetime of the loan. Details regarding the calculations are often proprietary, which makes it difficult to evaluate individual assumptions and estimates on their merit. However, the estimates broadly converge to the conclusion that major and regional banks may hold some ¥20–30 trillion in unrecognized loan losses.

NPL Disposal The government has called on major banks to remove loans to bankrupt and near-bankrupt borrowers from their balance sheets within two years—i.e., by end-March 2003—and new NPLs within three years

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from the date they were so classified. The FSA has recently requested banks to accelerate the disposal of loans newly classified as “in danger of bankruptcy” or below so that one-half are disposed of within one year and the majority (80 percent) within two years. The overall aim is to reduce the NPL ratio of these institutions by one-half (from 8.7 percent to 4.4 percent) by end-March 2005. The infrastructure for this process is now largely in place based on three main channels: court-led bankruptcy proceedings; informal out-ofcourt debt workouts, including through the recently established private sector guidelines for multicreditor out-of-court debt workouts; and the sale of assets to the Resolution and Collection Corporation (RCC), the Industrial Revitalization Corporation (IRC), or private sector restructuring funds. Loans by major banks to bankrupt and near-bankrupt borrowers amounted to ¥11.7 trillion at end-March 2001, and during FY2001 about one-half of these were removed from banks’ balance sheets. The current disposal plan, however, covers only a subset of outstanding NPLs. First, loans by major banks to borrowers requiring “special attention”—which are classified as NPLs under the Financial Reconstruction Law definition—are not included in those that have to be disposed of by end-March 2003. Second, while the FSA has called on the regional banks and smaller deposit-taking institutions to follow the same disposal timetable as the major banks, the disposal requirement has not been formally extended to these institutions. These omissions mean that only about one-third of the NPLs of deposit-taking institutions are explicitly covered by the initial disposal program, potentially diminishing the effectiveness of the reforms. Strengthening Bank Loan Classification and Provisioning Practices Concerns about the adequacy of loan classification and provisioning practices were heightened by last September’s collapse of Mycal—a large retailer—whose loans were overclassified (and underprovisioned) by banks before its bankruptcy. In response to a request from the prime minister, the FSA began conducting special inspections in October 2001 to ensure that banks are appropriately classifying loans and making sufficient provisions against problem loans on an ongoing basis. The inspections were concluded in April 2002, and incorporated in the FY2001 financial reports of the major banks. The special bank inspections focused on the classification of loans to large, potentially problematic borrowers at 13 major banks. The criteria for selecting the companies were that they should be large borrowers classified as “in need of special attention” or above at end-September

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TIM CALLEN AND MARTIN MÜHLEISEN

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2001, but whose stock prices, credit ratings, or other indicators of financial health had recently undergone significant change. The FSA found 149 companies that met the criteria, 98 of which were in the construction, real estate, nonbank financing, and retail sectors. The review was primarily carried out at the borrower’s main bank—the bank that plays the leading role with the borrower—and directly covered ¥12.9 trillion of loans (Table 2.5). But, as other banks have exposures to the same borrowers, the inspections are estimated by the FSA to have covered roughly double this amount of loans. The inspections resulted in 71 borrowers—with outstanding loans of ¥7.5 trillion—being downgraded at the main bank, with ¥4.7 trillion of these loans (about 30 percent of the total) being reclassified as nonperforming (¥3.7 trillion were reclassified as being in “danger of bankruptcy” or below). The reclassifications resulted in additional loan-loss charges for the banks of ¥1.9 trillion in FY2001. The special inspections were an important step in strengthening loan classification practices and raising provisioning levels, but they directly covered only a small subset of outstanding bank loans, and questions remain about the quality of other loans on bank balance sheets. The FSA appears to have taken a tough stance with the banks during the special inspections, as reflected in the significant proportion of covered borrowers that were downgraded. But, although the results of the inspections may have addressed some of the concerns about the treatment of loans to the largest borrowers, questions still remain about banks’ classification of loans to other borrowers. While the effective coverage of the inspections is higher than the 4 percent of outstanding bank loans that were actually inspected because of the flow-on to

Table 2.5. Results of the Financial Services Agency Special Inspections of Major Banks, April 2002

Borrower category+

Normal Needs attention Other Special attention In danger of bankruptcy and below Totals

Before Inspection (end-September 2001) ________________________ Number of Amount debtors (Yen, trillions)

50 99 56 43 0.0 149

3.2 9.6 6.4 3.2 0.0 12.9

After Inspection (end-March 2002) ______________________ Number of Amount debtors (Yen, trillions)

35 80 35 45 34 149

Source: Financial Services Agency.

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Current Issues Facing the Financial Sector

 29

Table 2.6. Adjustment to Banks’ Self-Assessment of Credit Risks After Bank of Japan’s Inspection

Banks Inspected FY99 FY00 FY01

39 87 97

Borrowers Assessed (a) 21,300 33,500 21,300

Rate of Borrowers Whose Adjustments Assessment Required Required (b/a) Adjustments (b) (Percent) 2,900 3,300 1,900

13.6 9.9 8.9

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Source: Bank of Japan.

non–main bank lending to the same firms, it was still limited.8 In particular, loans to small and medium-sized enterprises, which account for a large proportion of bank lending, were not covered. While the FSA expects that banks will apply the same standards used in the special inspections to all the loans on their books, it will be important for future inspections to ensure that this is indeed the case. In this context, it is worth noting that the annual bank inspections conducted by the Bank of Japan during FY01—which covered 97 banks—recommended that banks adjust their self assessments for 1,900 out of the 21,300 borrowers examined (Table 2.6). While this was a lower percentage of borrowers than in the preceding two years—which indicates that banks are continuing to make improvements—it also suggests that there is considerable scope for further strengthening their loan assessments. To improve onsite inspections, the FSA has recently announced two changes. First, a system of “de facto” resident inspectors for each major bank group is to be established within the FSA’s Inspection Bureau. This will enable each unit to concentrate on the financial institutions within that bank group, and is expected to improve the efficiency and effectiveness of the inspections. Second, to check the adequacy of bank operations in specific areas—for example, internal audit functions— special teams of experts will be established to conduct inspections in these areas across banking groups.9 In addition, a supplement to the in8The FSA has not released information on the proportion of bank lending that is accounted for by large borrowers. 9To improve transparency, banks have been required to disclose financial information on a quarterly basis from the first quarter of FY2002. While the quarterly disclosures— which will occur at the end of June and December—will not be as full as in the interim and full year results (which are reported at the end of September and March, respectively), it represents an important step. The main items that banks will be required to report are the amount of classified assets based on the FRL standard; capital adequacy ratio and Tier-1 capital; and information on investment securities (market value, book value, and unrealized gains or losses by major category) and derivatives.

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TIM CALLEN AND MARTIN MÜHLEISEN

spection manual has been issued to cover the treatment of loans to small and medium-sized enterprises. In the October 2002 policy package, the FSA announced that it would conduct a further round of special inspections; ask banks to provision against “special mention” loans on the basis of a forward-looking assessment of its value (rather than historical loss rates as at present); and apply stricter assessments of corporate restructuring plans and collateral valuations.

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Reducing Exposure to Equity Market Risk Japanese banks have reduced their equity holdings in recent years, although their exposure to equity price risk remains high. During FY2001, major banks sold a further ¥5 trillion of equity, although they also acquired some additional equity through debt-equity swaps as part of corporate restructuring plans. But, at about ¥26 trillion (150 percent of Tier-1 capital), the equity portfolios of the major banks remain large. These holdings—particularly since the introduction of mark-to-market accounting last April—mean that bank earnings and capital are exposed to significant equity price risk. For example, a 10 percent decline in the TOPIX is estimated to result in a valuation loss on bank equity holdings of ¥2!/2 trillion.10 Allowing for a 40 percent tax carry-forward, this would result in a reduction in Tier-1 capital of the major banks of about ¥1.5 trillion (0.4 percentage points of the Tier-1 capital ratio). Life insurance companies—which also hold large equity portfolios—are exposed to significant equity price risk as well. Going forward, the behavior of foreign investors is likely to be particularly important for Japanese equity markets as foreigners hold about one-half of actively traded stocks. The government, concerned that the equity price risk faced by banks is excessive, has introduced new regulations to limit the size of bank equity holdings. Banks will be required to reduce their shareholdings to 100 percent or less of Tier-1 capital by September 2004.11 Banks, however, can request a one-year grace period for meeting this limit if their 10FSA estimate, based on the assumption of a 100 percent correlation between banks’ equity portfolios and the TOPIX. The exact valuation loss depends on the specific portfolio held by banks. If the correlation of the portfolios is less than 100 percent, the valuation loss would also be lower. For example, a 60 percent correlation would lead to valuation losses of about ¥1.5 trillion for the same decline in the overall equity price index. 11Even at this reduced level, banks’ equity holdings will remain significantly higher than in other OECD countries.

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Current Issues Facing the Financial Sector

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equity portfolio currently exceeds 150 percent of Tier-1 capital (and up to a two-year grace period if it exceeds 200 percent). If Tier-1 capital remains unchanged, this would require banks to sell about an additional ¥7 trillion of equity by September 2004. To aid in the disposal process, a Bank Shareholding Purchase Corporation (BSPC)—established with capital contributions from private banks and which will also be financed by government-guaranteed loans—has been set up to purchase equity from banks at market prices, and some of the shares will be repackaged for sale as exchange traded funds (ETFs).12 However, banks that sell equity to the BSPC are required to contribute 8 percent of their sales to the corporation to cover possible losses on the disposal of the holdings. As a result, the net effect on a bank’s capital is neutral, depriving banks of any capital relief they would have realized if they had sold the shares directly to the market. In September 2002, the Bank of Japan announced that it would purchase equities from banks that have stockholdings in excess of Tier-1 capital. In addition to equity market risk, banks also have significant exposure to Japanese government bonds (JGBs), and therefore also face considerable interest rate risk, although the government’s reform plans do not address this issue. Banks have been large purchasers of government bonds in recent years, although they turned sellers in FY2001; they have also recently acted to shorten the average maturity of their bond holdings. On top of their direct bond holdings, banks are also reported to have significant exposure to interest rate risk through derivative instruments. Private analysts believe that the inclusion of swap positions effectively doubles banks’ exposure to interest rate risk. While the volatility of JGB yields has remained low, the potential for a yield spike exists, particularly if households’ willingness to continue to (passively) invest in JGBs diminishes or the issuance of new debt increases sharply, perhaps because of the need for the government to underwrite the liabilities of the financial sector.13 An increase in yields would result in valuation losses on the banks’ JGB holdings and would affect bank capital. FSA estimates suggest that a 1 percentage point rise in interest rates reduces the value of major bank JGB holdings by ¥1!/4 trillion (assuming an average maturity of 3 years), and, after tax effects, this reduces the Tier-1 capital ratio by 0.2 percentage points. A related issue

12The BSPC has two accounts; a general account and a special account. The government-guaranteed loans are only available to fund the special account. Only shares purchased by the general account will be available for repackaging as ETFs. 13In contrast to the equity market, foreign investors are not large players in the domestic bond market, accounting for about 5 percent of outstanding bonds.

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TIM CALLEN AND MARTIN MÜHLEISEN

is the potential impact of a further sovereign rating downgrade on banks’ cost of capital and access to capital markets.

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Deposit Insurance and the Public Safety Net A blanket deposit guarantee was introduced in Japan in 1996 in response to a series of financial institution failures that undermined public confidence. It was originally due to be withdrawn in April 2001 but, in late 1999, the government decided to postpone the removal for a year because of concerns about the health of many financial institutions, particularly the regional banks and credit cooperatives, and because of the transfer of the supervision and inspection responsibilities for credit cooperatives from prefecture governments to the national government in April 2000. The guarantee for all but demand deposits was limited to a maximum of ¥10 million from April 1, 2002, but the removal of the blanket guarantee on demand deposits—which was to have taken place at end-March 2003—was delayed by a further two years.14 While the removal of the full guarantee on time deposits resulted in considerable deposit switching, there was no deposit flight out of the banking system as a whole. The potential for deposit movement was significant, as about ¥100 trillion of deposits (18 percent of the total) were affected by the change. Indeed, balances on time deposits in excess of ¥10 million declined by 25 percent (year on year) in March 2002, although bank deposits as a whole continued to grow in the months leading up to the guarantee’s removal as many of these time deposits were switched into demand deposits where the full guarantee still remains. Further, at the aggregate level, there was little evidence of deposit switching away from the regional banks to the major banks, although a number of weaker regional banks are reported to have experienced significant outflows. However, the removal of the guarantee on demand deposits—which would have affected a further ¥100 trillion of deposits—would have been a bigger test of the public’s confidence in the banking system since no deposits in excess of ¥10 million will then be insured. In such circumstances, contagion from weaker institutions could easily have spread. As it has partially moved away from the blanket deposit guarantee, the government has sought to assure depositors that it has an adequate 14In April 2002, the Deposit Insurance Corporation raised the deposit insurance premia on demand deposits by 12 percent to 0.094 percent and lowered it for time deposits by 5 percent to 0.08 percent.

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safety net in place in the event of systemic financial sector problems. Since the 1998 crisis, the financial sector safety net has been strengthened considerably. First, the political mechanism for crisis management was greatly simplified, enabling the prime minister to quickly authorize public capital injections—even against the will of the bank in question—after consulting with key policymakers.15 In such case, the Deposit Insurance Corporation has ¥15 trillion of funds in the Financial Crisis Account to draw on and intervene as necessary. These funds are available for capital injections, full coverage of deposits, and temporary nationalization in the event of systemic instability (Table 2.7). Even if a crisis were limited to a particular region, the government would be entitled to use public funds to facilitate bank transfers under the purchase and assumption framework, to inject capital into key institutions, or, if necessary, to temporarily reinstate blanket deposit guarantees.16 Nevertheless, the need to invoke the deposit insurance law’s systemic support provisions could be accompanied by considerable market volatility, and in such circumstances it would be essential to ensure that the framework was applied promptly and did not become subject of a protracted political debate.

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Increasing Bank Profitability While dealing with the existing NPL problem is essential, boosting profitability is the key to ensuring a healthy banking system in the medium term. By international standards, bank profitability in Japan is low, and boosting it will likely require the following elements. • Raising interest margins. Interest margins have been on a modest downward trend since the 1980s, reflecting the impact of financial deregulation and the decline in corporate demand for funds following the bursting of the asset price bubble. At about 1!/2 percent, the net interest margin of Japanese banks is considerably below that of their U.S. and U.K. counterparts, but broadly in line with that in Germany and above that in France (Figure 2.3). Bank of Japan analysis shows that the lower a firm’s credit rating, the 15The

deposit insurance law requires that the prime minister certify the presence of a financial crisis, following deliberations of the Conference for Financial Crisis (comprising the ministers of finance and financial affairs, the FSA commissioner, the cabinet secretary, and the Bank of Japan governor), in order to tap the Crisis Management Account. The ¥15 trillion in this account is currently regarded as sufficient to deal with additional bank failures, but might need to be expanded in case of a more widespread crisis. 16Regional institutions, in particular, are vulnerable to deposit shifts by local authorities who themselves are facing financial difficulties.

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Depositor protection (partly premium-funded)

Depositor protection (public loans and grants)

Lending to nationalized and bridge banks

Capital injections

Emergency measures for major and regional banks

General Account

Special Account2

Financial Reconstruction Account2

Financial Functioning Early Strengthening Account2

Crisis Management Account 62

0

25

18

17 (10+7)

2

70

0

25

18

23 (10+13)

4

70

15

16

10

23 (10+13)

6

70

15

10!/2

12

19!/2 (6!/2 +13)

13

} 29

0

8

5

15!/2

Used by March 20021

Source: Deposit Insurance Corporation; and Financial Services Agency. 1Most of the funds are expected to be recovered, except for ¥8!/2 trillion in government grants to cover depositor losses. 2Established under the Financial Functioning Early Strengthening Law in 1998. These accounts have to be maintained until public capital is repaid to the government by the banks. Only the crisis management account will be used in the event of a systemic crisis.

Total

Purpose

Limits (yen, trillions) _________________________________________________________ FY99 FY00 FY01 FY02



Account

Table 2.7. Bank Support Framework

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34 TIM CALLEN AND MARTIN MÜHLEISEN

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The RCC and the Market for Distressed Debt in Japan

 35

Figure 2.3. International Comparators of Bank Profitability (Percent of assets; 1995–99 average) 4.0 3.5

Net Interest Income

2.5

Non-Interest Income

2.0

3.0 2.5

1.5

2.0 1.0

1.5 1.0

0.5

0.5 0

2.0

Japan

France Germany United United Kingdom States

Net Fees and Commissions

0

4.0 3.5

Japan

France Germany United United Kingdom States

Operating Expenses

3.0

1.5

2.5 2.0

1.0

1.5 1.0

0.5

0.5 0

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2.5

Japan

France Germany United United Kingdom States

Net Income

0

Profits Before Tax 1.5

1.5

1.0

1.0

0.5

0.5

0

Japan

France Germany United United Kingdom States

France Germany United United Kingdom States

2.0

2.0

0

Japan

-0.5

Japan

France Germany United United Kingdom States

Source: OECD, Bank Profitability 2000.

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TIM CALLEN AND MARTIN MÜHLEISEN

wider the spread between the yield on its corporate bonds and its bank lending rate (Bank of Japan, 2001). This may suggest that banks are not adequately pricing their loans, particularly to higher risk borrowers, although it could also be due to the fact that the bank loan has some collateral backing while the bond is unsecured. Banks, however, do appear to be trying to boost margins. A Bank of Japan survey of senior bank loan officers indicates that banks have sought to increase their spreads for borrowers of medium and low ratings over the past six months, and that they will continue to pursue this for all borrowers in the near future.17 • Improving the quality of the loan portfolio. Banks will need to improve their credit assessment processes for new loans to raise the quality of their loan portfolios. The Bank of Japan survey, however, suggests that, if anything, banks have eased their standards for approving loan applications from firms and households over the past six months. This is particularly true for households and small firms, the latter possibly to meet mandated credit targets to small businesses. • Increasing fee-based income. With lending operations declining— owing to the lack of demand for credit because of the current economic downturn and the longer-term deleveraging trend in the corporate sector—banks will need to look at new profit avenues. By international standards, Japanese banks earn little in the way of fee-based income. While there has been some trend toward greater fee-based income from investment banking services such as consultancy on mergers and acquisitions, this will need to be expanded much further. By contrast, Japanese banks appear to already have a low cost structure relative to banks in other G-5 countries. Since the mid-1990s, banks have intensified their administrative cost-cutting efforts, particularly in the personnel area, and costs are well below those of their U.S. and U.K. counterparts. While the recent mergers among the major banks could result in additional cost savings, results to date appear mixed.18 Outright merger would appear more likely to result in improved efficiency than the holding company structure adopted in other 17Bank of Japan, “Senior Loan Officer Opinion Survey on Bank Lending Practices at Large Japanese Banks.” 18Restructuring among the major banks has continued. Effective April 1, 2002, the three main subsidiary banks in the Mizuho group (Daiichi Kangyo, Fuji, and Industrial Bank of Japan) were reorganized to form Mizuho Bank and Mizuho Corporate Bank; Sanwa Bank and Tokai Bank merged in January 2002; and Asahi Bank joined the Daiwa Bank holding company on March 1, 2002.

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Current Issues Facing the Financial Sector

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cases. The mergers, however, will need to lead to business synergies in order to boost profitability, rather than focus on cost-cutting. In addition to the actions that banks themselves can take, reforms that improve the environment in which banks operate will also be important. A key issue is the public sector’s role in financial intermediation in Japan. During the course of the 1990s, the importance of public sector financial institutions (GFIs) has increased. Postal savings now account for about 33 percent of household deposits, while the Postal Life Insurance Bureau accounts for 40 percent of personal insurance assets. Given the competitive advantages that postal savings and government financial institutions enjoy—including an implicit government guarantee on borrowing and exemptions from paying corporate tax and deposit insurance premiums—they act to squeeze private banks on both sides of their balance sheets. Recognizing the need to reduce the role of public entities in the financial sector, the government has begun reforms of the postal savings system and GFIs. The Postal Services Agency will be transformed into a public corporation from FY2003, although no firm date has been set on which the corporation will begin paying fully equivalent deposit insurance premiums and corporate tax payments, and therefore it is likely to do little to level the playing field between the postal savings system and private financial institutions in the near term. With regard to GFIs, the Government Housing Loan Corporation is to be abolished, although some of its operations will be transferred to an independent administrative agency, while the future of the other GFIs will be considered by the Council on Economic and Fiscal Policy. The FSA is also to begin to inspect the corporatized Postal Savings System and GFIs from April 1, 2003.

Life Insurance The financial position of life insurance companies weakened during FY2001. Profitability continues to suffer from negative yield spreads— caused by the excess of guaranteed yields on existing life insurance policies over low returns on insurer-held assets—although insurers have so far been able to maintain reported solvency margins above the 200 percent minimum as they benefited from better-than-expected mortality trends (Table 2.8). Results indicate that most major life insurers experienced a drop in their solvency ratio during FY2001. This has been accompanied by a shrinkage in new business underwriting and a pickup in policy cancellations at some weaker insurers. In response to the difficult financial conditions, life insurance companies have continued to

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TIM CALLEN AND MARTIN MÜHLEISEN

Table 2.8. Financial Indicators of Life Insurance Companies (End-March 2002, unless otherwise stated) Base Profit Basic Indicators (Yen, billions) _______ _________________________________________ ____________________ Policy cancellation Total Premium and lapses assets income _______________________ (Percent of total Negative (Yen, trillions) policies) Total spread

Nippon Dai-Ichi Sumitomo Meiji Yasuda Mitsui Asahi Taiyo Daido Fukoku

45.2 29.8 23.0 17.1 9.8 8.3 7.7 6.8 6.0 4.8

5.7 4.0 2.9 2.3 1.4 1.0 1.1 1.0 1.1 0.8

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Securities Portfolio ___________________________ Unrealized Of which: gains Equity (Yen, billions)

Nippon 1,400 Dai-Ichi 526 Sumitomo –113 Meiji 336 Asahi –35 Yasuda 6 Mitsui –68 Taiyo 31 Daido 42 Fukoku 35

1,443 5 –356 62 –502 –40 –180 66 19 –30

7.8 8.6 10.3 10.3 10.9 11.9 15.4 8.0 9.0 6.2

562 378 299 259 184 106 106 14 110 57

340 255 237 79 39 88 106 66 6 35

Solvency Ratio _____________________________________ March 2000 March 2001 March 2002 (Percent)

1,096 866 676 731 733 809 677 1,050 1,004 907

778 682 551 667 543 603 493 807 758 779

714 593 535 609 418 613 511 769 772 708

Sources: Fitch IBCA.

restructure their operations. Progress is being made in closing overseas branches, with Asahi Life completely withdrawing from overseas operations. Some companies are also considering demutualizing; Daido Life went public in April 2002, and Taiyo Life is expected to follow. To try and maximize the value of their sales network and achieve operating cost reductions, several of the large life insurance companies have opted to merge (for example, Yasuda Life and Meiji Life) or to enter comprehensive business relationships with other life insurers or in some cases non–life insurance companies (for example, Dai-Ichi Life and Yasuda Fire & Marine).

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Life insurance companies face a number of risks in the period ahead. First, while they conduct their financial operations on a relatively conservative basis—with foreign currency positions largely hedged and little exposure to derivatives markets—their large equity portfolios are subject to considerable market risk. Second, life insurers and banks have continued to augment their financial links by increasing equity and subordinated debt cross-holdings to maintain capital in excess of regulatory standards (Table 2.9). In view of the relatively fragile position of some of the weaker institutions in both sectors, financial difficulties in one sector could affect the other, including through asset price contagion and possible losses on cross-debt holdings. The risks nevertheless appear manageable. First, the government has successfully handled recent life insurance failures, ensuring a smooth transition of ownership to largely foreign institutions without the need for public funds.19 Second, although bank failures would have a disproportionately larger influence on the health of insurance companies than vice versa—given that insurance companies have much larger exposures to banks than banks do to insurance companies—market analysts generally expect the government to use the bank support framework to shield life insurers from critical losses. Third, the government retains regulatory means to shield life insurers from a possible rise in long-term interest rates. For example, government bond holdings could be exempted from the introduction of mark-to-market rules in April 2003, on the grounds that bonds held to maturity provide a legitimate hedge for insurers’ long-term liabilities.

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Japanese Financial Institutions and International Markets Risks of a significant withdrawal of Japanese investors from overseas asset markets and the repatriation of capital into Japan appear low at this juncture. Japanese financial institutions are significant investors in overseas markets. In the U.S. treasury securities markets, Japanese investors—particularly large life insurers—reportedly hold a share of up to one-fifth of actively traded bonds.20 In the wider U.S. bond market, 19The fund established by the life insurance industry—the Life Insurance Policyholders Protection Corporation—to protect policyholders of bankrupt companies is almost exhausted (¥538 billion of its ¥560 billion assets have been used). Two years ago, the government established a ¥400 billion fund to supplement the industry’s own fund to maintain the confidence of policyholders, but this will expire at end-March 2003. Consideration is currently being given to whether this deadline should be extended. 20Combined foreign securities holdings of the life insurance sector amounted to about $230 billion as of October 2001, or about one-fifth of all privately held foreign assets.

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TIM CALLEN AND MARTIN MÜHLEISEN

Table 2.9. Cross-Holdings Among Japanese Life Insurers and Banks (As of March 2001; yen, billions) Exposure to Banks Borrowings from Banks __________________________________________ ________________________________ Bank Subordinate (Percent Foundation Subordinate stocks loans Total of assets) fund loans Total

Nippon 1,133.5 Dai-Ichi 967.2 Sumitomo 343.0 Meiji 693.7 Asahi 357.7 Yasuda 434.6 Mitsui 93.5 Taiyo 194.0 Daido 81.9 Fukoku 37.8

932.3 766.1 555.4 739.3 577.8 476.4 402.0 356.3 176.7 154.6

2,065.8 1,733.3 898.4 1,433.0 935.5 911.0 495.5 550.3 258.6 192.4

4.7 5.6 3.8 8.2 8.4 8.8 5.1 7.5 4.4 4.0

450 150 169 80 50 130 69 27 30 0

0 100 395 0 273 100 245 85 0 0

450 250 564 80 323 230 314 112 30 0

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Sources: Fukao and JCER (2002); and Nikko Salomon Smith Barney.

Japanese holdings accounted for about 2 percent of outstanding public and private issues at the end of 2000. Japanese investors also hold substantial bond market shares in Europe and in some Asian and Latin American emerging markets. Holdings of foreign equity, however, are generally much smaller. The recent difficulties in the bank and life insurance sectors have raised international concerns over a possible withdrawal of Japanese investors from overseas asset markets and the repatriation of capital into Japan. Market analysts generally consider that large-scale capital repatriation is unlikely in current circumstances. By offering attractive risk-adjusted returns, notwithstanding relatively high costs of currency hedging, foreign investments provide an important source of income for Japanese financial institutions. Consequently, a decision to repatriate large amounts of capital would likely be made only to rebalance portfolio risks following significant losses on other domestic or foreign assets, or in the unlikely situation of extreme liquidity shortages. Insurers with the largest presence in foreign markets are generally those with the most solid financial position, and they are also the most likely to enjoy systemic protection by the government. Risks of a further withdrawal of Japanese banks from international loan markets also appear manageable, although the impact in some Asian countries could be significant. Japanese banks still account for a considerable share of international bank lending, with a consolidated foreign exposure of $1.2 trillion (according to Bank for International Settlement statistics), the second largest global exposure behind German banks. While some of this exposure reflects the stock of loans committed earlier, Japanese banks have once again become more active in foreign markets in recent years, particularly in the syndicated loan mar-

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Current Issues Facing the Financial Sector

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ket. Concerns have been raised that their financial difficulties could force Japanese banks to curtail their overseas lending. However, were this the case, it would not have as significant an impact on industrialized economies as it did in the early 1990s (Peek and Rosengreen, 1997, 2000), although in Asian emerging economies Japanese banks still account for a substantial share of foreign bank lending. A large share of these loans are linked to FDI-related projects, and a decline in lending could affect growth prospects in the region. In recent years, foreign financial institutions have reduced their exposure to Japanese banks. The supply of capital to Japanese banks has been cut back, and Japanese bank credit risk has largely been limited to short-term collateralized lending (mostly repos) or short-dated swaps. Some foreign banks may recently have increased their exposure amid the large demand for dollar swaps by domestic institutions. However, these banks typically hold their yen assets at the Bank of Japan (accounting for a considerable part of the recent reserves increase) and thus only face the apparently small currency repayment risk in the forward leg of the transaction. Moreover, since Japanese financial institutions have not been very active in markets for complex financial instruments, market participants are not particularly concerned about exposures—for example, in the credit derivative markets. According to their estimates, nominal amounts outstanding in Japan account only for about $100 billion, or 10 percent of the global credit derivatives market. Foreign banks have pared down their dollar-denominated exposure to corporate borrowers located in Japan in recent years, but this has been more than offset by an increase in yen-denominated lending. According to BIS statistics, banks’ international claims against Japanese borrowers fell by about $100 billion between late 1999 and the end of September 2001 (to $513 billion), 90 percent of which was accounted for by a decline in lending to the nonbank sector. However, consolidated banking statistics, which include local exposure of subsidiaries in Japan, show a $150 billion increase in claims on Japan over the past two years (Table 2.10). This appears consistent with the increased presence of foreign institutions in the Japanese market—including through acquisitions of local institutions—led by German, Swiss, and U.S. banks. Although the quality of locally held assets could clearly be affected during a crisis, the bulk of this exposure is vis-à-vis foreign exporters and high-quality Japanese borrowers, and thus appears relatively secure.

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TIM CALLEN AND MARTIN MÜHLEISEN

Table 2.10. Consolidated Foreign Claims of International Banks on Japan (By nationality of banks; U.S. dollars, billions) September 2001 Total Germany Switzerland United States France United Kingdom Netherlands

588.8 96.3 73.4 63.2 53.1 46.9 10.7

June 1999 440.9 37.1 ... 18.8 27.5 15.3 23.9

Source: Bank for International Settlements.

References Bank of Japan, 2001, “Developments in Profits and Balance Sheets of Japanese Banks in Fiscal 2000 and Banks’ Management Tasks,” Bank of Japan Quarterly Bulletin, Vol. 9 (November). ———, Senior Loan Officer Opinion Survey on Bank Lending Practices at Large Japanese Banks, various issues. Fukao, Mitsuhiro, and Japan Center for Economic Research, eds., 2002, The Life Insurance Crisis Will Continue (Seiho Kiki wa Owaranai, in Japanese) (Tokyo: Toyo Keizai Shimposha).

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Peek, Joe, and Eric Rosengreen, 1997, “The International Transmission of Financial Shocks: The Case of Japan,” American Economic Review, Vol. 87 (September), pp. 495–505. ———, 2000, “Collateral Damage: Effects of the Japanese Banking Crisis on Real Activity in the United States,” American Economic Review, Vol. 90 (March), pp. 30–45.

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3 Banks and Credit in Japan GIOVANNI DELL’ARICCIA

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T

his chapter investigates how the quality of bank portfolios and the degree of corporate indebtedness have affected the evolution of bank credit in Japan. It uses panel data techniques to estimate empirically how bank credit growth relates to the nonperforming loans ratio and the loan-loss reserve ratio on the banking side, and to leverage and bank dependence on the corporate side. It employs a three-dimensional panel in which Japan’s bank credit is disaggregated by firm size, industrial sector of the borrowing firm, and by the specialization of the lending bank. The prolonged period of weak domestic growth accompanied by a consistent contraction in aggregate bank credit provides the motivation for this chapter. The issue of whether the contraction of bank credit stems from weaknesses in the banking system or from lack of demand in the corporate sector is important from a policy standpoint. Two main, not necessarily conflicting, views have emerged. The first view is that the weak balance sheets of Japanese banks caused by the bursting of the 1980s bubble and by poor governance has been the main factor behind the contraction in aggregate bank credit and, hence, behind Japan’s weak economic performance in the past decade.1 According to this view, a major cleanup of banks’ balance sheets, possibly accompanied by major structural reforms to improve corporate governance and foster competition, is a prerequisite for restoring selfsustaining growth in Japan. The second, and less common, view also 1See,

for example, Atkinson (2001) and Lyons (2002).

43

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44



GIOVANNI DELL’ARICCIA

focuses on the burst of the 1980s bubble, but places the causes of slow growth in the corporate sector. Japan’s situation is blamed on the high levels of corporate leverage, which have caused a reduction in investment, leading to slow productivity growth and to a prolonged contraction in aggregate domestic demand. According to this view, the absence of bank credit growth is the consequence of the problem rather than its cause. Consequently, the focus should be on corporate sector reforms and on macroeconomic policies to sustain domestic demand rather than on the cleanup of the banking system.2 The existing empirical literature has found mixed evidence on whether balance sheet problems have had an impact on bank credit growth in Japan. Bayoumi (2001) compares four alternative explanations for Japan’s weak growth performance in the 1990s, and suggests that the disruption of financial intermediation caused by the collapse in asset prices was the main factor. Motonishi and Yoshikawa (1999) use survey data to investigate whether real factors or financial factors were the main impediment to corporate investment in the 1990s. They find that overall real profitability was much more important than banks’ willingness to lend. However, they find evidence of a credit crunch in 1997. Woo (1999) reaches similar conclusions using bank balance sheet data. Finally, a few studies have found that the effects of the introduction of risk-based capital requirements on banks’ behavior were not uniform across banks (see Woo, 1999, for a review). This chapter draws on Woo’s work and on other studies linking bank credit growth to bank portfolio quality,3 but extends that methodology by including corporate sector variables in the regressions. The methodology used in this chapter has two main advantages. First, it allows the exploitation of cross-sectoral heterogeneity to identify the individual contribution of banking variables and corporate variables, reducing the endogeneity problems that typically arise with time-series of aggregate data. The relationship between economic growth (and hence the demand for credit) and bank portfolio quality is intrinsically bidirectional: slow growth weakens borrowers’ ability to repay existing loans and reduces the availability of new profitable lending opportunities, hindering bank profitability; a weakened banking system, burdened with nonperforming loans, may not effectively allocate liquidity to the real economy and hence reduces real growth. Thus, in time-series studies, it is difficult to establish the direction of causality and disentangle the two effects. The second advantage of using sec2See 3See,

Koo (2001, 2002). for example, Peek and Rosengren (1995) and Bernanke and Lown (1991).

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Banks and Credit in Japan

 45

toral data is that it allows simple techniques to reduce omitted variable problems. Indeed, the inclusion of multiple sets of fixed-effects controls for any factor that does not vary simultaneously across at least two dimensions of the panel. The results in this chapter suggest that both corporate sector and banking sector weaknesses share the blame for negative credit growth in recent years. On the corporate side, the chapter finds that a high initial degree of bank dependence and, to a lesser extent, high levels of initial corporate leverage, were detrimental to bank credit growth in the period considered. On the banking side, the paper finds that credit growth was lower for banks with a higher initial proportion of nonperforming loans and a lower initial loan-loss reserve ratio. The policy implications of these results are not surprising. The resolution of balance sheet problems in both the banking sector and the corporate sector is a prerequisite for restoring self-sustaining growth.

A Few Stylized Facts This section presents a few stylized facts on the evolution of the structure of Japan’s financial system and credit allocation in the past decade. In particular, it documents the central role still played by the banking system notwithstanding the financial reforms of the 1990s.

Copyright © 2003. International Monetary Fund. All rights reserved.

Central Role of Banking Institutions in Japan The Japanese financial system continues to rely heavily on intermediated finance to channel liquidity to sectors with financial deficits. Financial reforms initiated in the early 1990s gradually allowed financial institutions to expand the scope of their activities, offered households more options to diversify their financial investments, and opened the alternative of direct financing to borrowers. However, over the course of the 1990s, depository corporations have seen their market share in the financial system reduced only slightly. Their assets declined from about 58 percent of the financial sectors’ total in 1990 to just below 52 percent in 2000. As a result, the weight of deposit-taking institutions has remained well above the level in the United States, and it is more or less in line with that in other bank-centered systems like Germany or Italy. Although depository corporations have essentially maintained their central role, the relative weight of different kinds of institutions has changed. Banks have remained dominant, but have progressively lost market share to the Postal Savings System. In terms of assets, banks’ share within depository corporations declined from 83 percent in 1989

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GIOVANNI DELL’ARICCIA

to 77 percent in 2000, and the Postal Saving System’s share increased from 10 percent to 20 percent. A similar reallocation occurred on the deposit side, where the market share of banks declined from about 84 percent in 1989 to 75 percent in 2000. On the asset side, these compositional changes reflected, at least in part, the decreased demand for funds originating in the corporate sector and the increased demand for funds emanating from the government. On the deposit side, they were likely caused by the increased preference of Japanese households for safe assets. Japanese households continue to rely on holdings of currency and deposits as the main vehicle of financial investment. The reluctance to invest in riskier assets can explain, at least in part, the limited increase in the role of nonintermediated finance. In the past, financial sector regulation and tax incentives favored intermediated funding through deposit-taking institutions over market financing. The reform process culminated with the so called “Big Bang,” which fully liberalized Japanese financial markets and expanded households’ investment options. However, there is little evidence of a substantial change in saving patterns toward riskier forms of investment like corporate bonds and shares. On the contrary, over the 1990s, partly because of the decrease in stock prices, the share of currency and deposits (including postal savings) and the share of insurance and pension reserves increased by about 5 percent and 7 percent, respectively. According to the most recent data (March 2001), about 54 percent of Japanese households’ financial assets were held in currency or deposits (the share in the United States is below 10 percent). The absence of a significant shift in the allocation of households’ financial savings may just reflect a slow reaction to the recently implemented reforms. However, data from the Flow of Funds Accounts suggest that over the 1990s new holdings of currency and deposits (including postal savings) represented an average of 60 percent of new financial investments by households.4 It is then difficult to rule out the possibility that uncertain economic prospects and major failures involving securities companies played a role in increasing households’ propensity for safe investments and counteracted the effects of financial reforms. If that were the case, policies aimed at enhancing the transparency and improving the reputation of nonbank financial intermediaries may be needed to convince Japanese households to invest in riskier assets.

4See

Bank of Japan (2001a).

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Evolution of Bank Dependence in the Corporate Sector In the 1970s and early 1980s, Japanese firms relied heavily on banks for their external finance compared with their American counterparts. Hoshi and Kashyap (1999) report that in 1980 the bank debt-to-total-assets ratio of large Japanese firms was about three times that of large American firms. The difference was much less pronounced for Japanese small firms, whose ratio exceeded that of American firms by only 50 percent. The financial reform process, started in the mid-1970s, gradually opened the Japanese capital markets, especially expanding the fundraising options available to large firms. As a result, large firms, particularly those in the manufacturing sector, progressively reduced their dependence on the banking system by increasingly relying on capital markets for their external financing needs. Table 3.1 documents this trend using survey data from the Ministry of Finance’s “Quarterly Report of Incorporated Enterprise Statistics.” Between 1971 and 1991, the overall average leverage of large firms remained essentially stable. However, the shift from bank financing to capital market financing is evident, with the ratio of bank debt-to-total debt declining by almost 20 percent to about 69 percentage points. The trend is even more pronounced for large firms in the manufacturing sector, where the decrease in bank dependence was also coupled with a decrease in total leverage. The debt-to-assets ratio declined by about 13 percentage points to 29 percent, and the bank debt-to-total debt ratio declined by almost 35 percentage points to 54 percent. Things were different in the nonmanufacturing sector, where large firms increased their leverage by about 10 percentage points to 51 percent, and where bank dependence declined by only 11 percentage points. Small firms, and, to a lesser extent, medium-sized firms that did not have access to nonintermediated finance, followed the opposite path. These firms benefited from the bank liquidity “freed” by large firms switching to bond markets, and increased their reliance on external capital and bank financing. Between 1971 and 1991, their leverage increased by more than 10 percentage points to about 50 percent. Lacking alternative sources of external finance also meant an increase in bank dependence, with their bank debt-to-assets ratio increasing in line with leverage and their bank debt-to-total-debt ratio remaining stable and close to 90 percent. This trend was more pronounced for firms operating in the nonmanufacturing sector. Indeed, the increase in leverage for small firms in the nonmanufacturing sector was about twice as large as that in the manufacturing sector. The difference was even more striking for medium-sized firms, whose leverage and bank dependence increased in line with those of small firms in the nonmanufacturing

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Nonmanufacturing __________________________________ A B C D 35.6 41.9 28.1 27.2 38.9 40.8 39.7 35.3 42.4 45.5 42.8 39.0 51.7 51.0 51.9 52.4 46.4 43.2 45.1 49.8

Q3 Q3 Q3 Q3 Q3

Q3 Q3 Q3 Q3 Q3

1961 1971 1981 1991 2001

1961 1971 1981 1991 2001

Manufacturing __________________________________ A B C D 30.5 30.9 32.1 25.7 35.5 37.8 32.5 29.1 30.9 31.7 29.8 29.3 22.5 15.8 29.3 36.2 21.5 14.7 26.5 36.8

100.0 86.4 86.5 88.6 84.8

All industries __________________________________ A B C D 30.7 32.2 29.9 26.5 34.2 36.6 33.2 29.3 34.0 34.5 34.7 32.9 36.2 28.8 41.7 43.6 31.4 23.3 34.6 40.5

99.3 88.5 88.8 85.7 79.9

(Bank debt/assets; percent)

84.6 88.9 88.8 54.4 60.5

88.9 88.5 88.3 69.2 71.7

Manufacturing __________________________________

(Bank debt/total debt; percent)

All industries __________________________________ A B C D 88.1 82.8 99.2 99.6 86.7 87.5 86.3 84.4 86.3 84.9 87.6 87.7 79.4 68.9 88.0 87.3 76.2 66.0 82.6 83.5

80.8 85.7 81.8 74.8 68.3

99.0 84.8 87.1 88.5 83.3

99.3 83.5 88.1 87.0 83.2

Nonmanufacturing __________________________________ A B C D 31.0 33.9 27.8 27.0 33.0 35.0 33.7 29.4 36.1 37.3 37.3 34.3 42.6 38.2 46.0 45.6 36.0 29.5 37.5 41.4

87.2 84.9 85.2 82.3 77.5

Nonmanufacturing __________________________________

Source: Ministry of Finance, Quarterly Report of Incorporated Enterprise Statistics. Size of firms (capital): A is all sizes, B is ¥1 billion or over, C is ¥100 million to ¥1 billion, D is ¥10–100 million.

Q3 Q3 Q3 Q3 Q3

1961 1971 1981 1991 2001

Manufacturing __________________________________ A B C D 34.3 36.5 32.4 25.7 40.2 42.5 36.7 33.7 35.0 35.7 33.5 33.8 32.6 29.0 34.2 40.9 30.0 24.3 33.1 43.4

(Debt/assets; percent)

All industries __________________________________ A B C D 34.9 38.9 30.2 26.6 39.5 41.8 38.4 34.8 39.4 40.6 39.6 37.6 45.6 41.8 47.3 49.9 41.2 35.2 41.9 48.5



Table 3.1. Leverage and Bank Dependence of Japanese Corporates 1961–2001

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48 GIOVANNI DELL’ARICCIA

Banks and Credit in Japan

 49

sector, but instead decreased slightly in the manufacturing sector. One possible explanation for such difference is the larger use of collateralizable capital goods in the manufacturing sector, since, for a large part of the 1970s, regulation on bond issuance still imposed collateral backing for bonds. The 1990s witnessed a trend toward deleveraging in the corporate sector. Between 1991 and 2001, debt-to-asset ratios declined, although in some cases only moderately, for all sectors and firm categories, with the exception of small firms in the manufacturing sector, which experienced a 3 percentage point increase to 43 percent. The importance of corporate sector deleveraging in the second half of the 1990s is confirmed by data from the Flow of Funds Accounts. Since 1998, the corporate sector has turned from running a financial deficit to a financial surplus, mainly through a substantial reduction in outstanding loans not compensated for by the issuance of other securities (Figure 3.1). The reduction in outstanding loans resulted from both the write-off and the repayment of existing loans. The examination of data on net flows and stock changes reveals, through the “stock reconciliation” figures, that loan write-offs played a major role in the mid-1990s and that, more recently, actual loan repayment was the major force behind the decline in outstanding loans (Figure 3.2). Corporate deleveraging brought about a further decline in bank dependence. Overall, the ratio of bank debt-to-total assets has declined

Figure 3.1. Fund Raising by Non-Financial Corporations Copyright © 2003. International Monetary Fund. All rights reserved.

(Yen, trillions) 60 50 40 30 20 10 0 –10 –20 –30

Loans Shares Other securities FY1990 FY91

FY92

FY93

FY94

FY95

FY96

FY97

FY98

FY99 FY2000

Source: Bank of Japan.

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GIOVANNI DELL’ARICCIA

Figure 3.2. Decomposition of Outstanding Loan Growth Rate (Percent) 10 8 6 4 2 0 –2 –4

Due to write-offs

–6

Due to flow

–8 FY1990 FY91

FY92

FY93

FY94

FY95

FY96

FY97

FY98

FY99 FY2000

Copyright © 2003. International Monetary Fund. All rights reserved.

Source: Bank of Japan.

from 36.2 to 31.4 percent in the past 10 years. However, bank debt still represents about 76 percent of total corporate debt, down only 3 percentage points, indicating that deleveraging rather than the recourse to alternative sources of external finance played the main role in the decline in bank dependence. Again, that decline was not uniform: large and medium-sized firms reduced bank dependence more than small enterprises, and nonmanufacturing firms reduced it more than manufacturing firms. Differences in borrowing patterns across firms of different size can be explained by the different access to alternative forms of credit, as confirmed by the sharper decrease in the percentage of bank debt over total debt for large and medium-sized enterprises. Differences across sectors can instead be explained by the fact that during the previous 20 years, manufacturing firms had significantly reduced their reliance on bank lending (with bank debt-to-assets ratios declining from 32 percent to 16 percent), while bank dependence in the nonmanufacturing sector had either increased or remained stable. Evolution of Bank Credit Allocation From the late 1970s to the mid-1990s Japan experienced strong growth in bank credit. Overall, outstanding loans almost tripled between 1981 and 1996. At the same time, the composition of bank credit changed slowly, with the share of corporate lending in total loans

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Table 3.2. Bank Credit Allocation (Index 1980=100) Total Index 1981.01 1986.01 1991.01 1996.01 2001.01

107.4 170.1 251.7 310.0 285.8

Local Governments ________________ Index Share

Individuals ________________ Index Share

Corporates ________________ Index Share

113.2 160.3 142.2 401.0 521.0

107.1 146.2 327.1 430.3 476.4

107.4 173.6 242.4 291.7 255.6

1.1 1.0 0.6 1.4 2.0

12.3 10.6 16.1 17.2 20.6

86.5 88.3 83.3 81.4 77.4

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Source: Bank of Japan.

decreasing over the period by about 5 percentage points in favor of loans to individuals (Table 3.2).5 Bank lending, however, has fallen since the mid-1990s, and the trend toward more focus on local governments and individuals, and less on corporates, accelerated. Loans to corporates declined by about 14 percent in nominal terms between 1996 and 2001, while loans to local governments and loans to individuals increased by 30 percent and by about 10 percent, respectively. These compositional changes reflected, at least in part, substantial write-offs of existing loans, and factors originating in the real economy like the decreased demand for funds in the corporate sector and the increased demand for funds from the government.6 This is confirmed by the fact that there has been significant variability in bank lending across different industrial sectors. Outstanding loans to firms operating in traditional sectors such as manufacturing, trading, and construction contracted considerably, while lending to firms in “new” industries such as transportation and communications expanded significantly. In addition, even in sectors that witnessed an overall contraction in bank lending, the evolution of outstanding loans has not been uniform. For example, loans to utility companies increased in the first part of the 1990s, decreased sharply after 1995, and then increased again at the end of the decade. Disaggregated data (available for the period 2000–01) provide further evidence of heterogeneity of bank credit growth at the industry level. The data confirm that a reallocation of bank portfolios toward local governments and individuals has been taking place. They also confirm that there has been some heterogeneity within the corporate sector (see Figure 3.3, which 5Data 6See

in Table 3.2 include trust accounts of domestically licensed banks. Bank of Japan (2001a).

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30 25 20 15 10 5 0 –5 –10 –15 –20 –25 –30

25

20

15

10

5

0 Motor vehicles Electric & gas utilities Other manufacturing Textiles Nonferrous metals

–5

–10

–15

–20

–10

–5

–15

–20

Food & beverages Other manufacturing Processing Wholesaling Wholesaling & retailing Retailing Electrical machinery

0

–25

Source: Bank of Japan.

Japan's Lost Decade : Policies for Economic Revival, International Monetary Fund, 2003. ProQuest Ebook Central, Communication Precision machinery Retailing

Iron & steel Other manufacturing Wholesaling & retailing Leasing Real estate Other nonmanufacturing Nonferrous metals Electrical machinery

Lumber & lumber products

5



Real estate Basic materials Shipbuilding & heavy machinery Ceramics, stone & clay Transport machinery Transport & communication Nonmanufacturing All industries Motor vehicles Textiles Precision machinery Services Transportation Leasing Pulp & paper Manufacturing Industrial machinery Lumber & lumber products Processed metals

10

Construction Processed metals Other transport machinery Petroleum & coal products Ceramics, stone & clay Motor vehicles Transport machinery Construction & real estate Food & beverages Chemicals Pulp & paper Shipbuilding & heavy machinery Electric & gas utilities Basic materials Wholesaling Textiles Transportation Industrial machinery Services Manufacturing All industries Nonmanufacturing Transport & communication Processing

15

Communication Leasing Petroleum & coal products Transport & communication Pulp & paper Chemicals Other nonmanufacturing Other transport machinery Lumber & lumber products Nonmanufacturing All Industries Industrial machinery Basic materials Construction Wholesaling Ceramics, stone & clay Wholesaling & retailing Manufacturing Iron & Steel Services Shipbuilding & heavy machinery Construction & real estate Electrical machinery Food & beverages Real estate Transportation Processing Retailing Transport machinery Precision machinery Processed metals

20

Petroleum & coal products Nonferrous metals Communication Electric & gas utilities Other transport machinery Other nonmanufacturing Iron & steel Chemicals Construction Construction & real estate

52 GIOVANNI DELL’ARICCIA

Figure 3.3. Bank Credit Growth by Sector

(2000Q3–2001Q3 average; percent) Large Firms

Medium Firms

Small Firms

Banks and Credit in Japan

 53

describes bank credit growth rates by sector between 2000Q3 and 2001Q3). In the case of large firms, roughly one-third of the industries considered experienced positive bank credit growth rates, with nonmanufacturing industries showing the strongest growth rates, while in the case of small and medium-sized enterprises only a handful of industries registered an increase in bank credit over the period.

Bank Balance Sheets, Corporate Balance Sheets, and Credit Growth: A Panel Data Analysis In the previous sections, this chapter documented the fact that the aggregate contraction of bank lending since the mid-1990s has been hiding a more complex picture at the sectoral level, where different industries and categories of firms were characterized by different rates of credit growth. In addition, corporate lending by different categories of banks also followed heterogeneous dynamics. In what follows, a simple econometric model to link bank credit growth to industry-specific and firm-size-specific variables on the borrower side and to bank-groupspecific variables on the lender side is constructed and estimated. It is hoped that this more formal examination of the data will shed some light on the factors behind the consistent and prolonged contraction in aggregate credit experienced by Japan in recent years.

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Empirical Methodology The methodology in this chapter consists of regressing the growth rate of bank credit for the year ending in 2001Q3 on industry-specific and firm-size-specific dummies, lagged firm-size/industry variables, and lagged bank group variables. In the main specification, the growth rate of credit (c) from bank group k to industry i and size group j is regressed on the two sets of fixed effects, on firm leverage and bank dependence in industry i and size group j, on the initial share of credit that bank group k allocated to industry i and size group j, and on bank nonperforming loan ratio and loan-loss reserve ratio in bank group k. The resulting model is (time index omitted): ckij = α + ϕ1LEVERij + ϕ2BANKDEPij + ϕ3NPLk + ϕ4RESERVESk + ϕ5SHAREkij + Φ6INDUSTRY_FEi + Φ7SIZE_FEj + εkij .

In an alternative specification, the two banking variables are substituted with an index of the financial strength of the bank group based

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GIOVANNI DELL’ARICCIA

on an average of Moody’s and Fitch rating measures. In that case, the model becomes (time index omitted):

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ckij = α + ϕ1LEVERij ϕ2BANKDEPij + ϕ3RATINGk + ϕ4SHAREkij + Φ5INDUSTRY_FEi + Φ6SIZE_FEj + εij .

In both specifications, a negative coefficient for LEVER would support the view that the high corporate leverage has been a factor in the weak performance of bank lending. Similarly, BANKDEP is also expected to have a negative coefficient, since firms have been trying to diversify their sources of external finance and reduce their dependence on bank credit. A negative coefficient for SHARE would also indicate that firms have been trying to reduce their reliance on a specific bank and, at the same time, that banks have been trying to reduce their exposure to their main borrowers. In the first specification, a negative coefficient for NPL would indicate that the poor quality of banks’ portfolios has impaired their ability to extend new credit to corporates. A positive coefficient for RESERVES would suggest that banks that took bolder steps to address their balance sheet problems have been those relatively more active in extending new credit to corporates. In the second specification, RATING is suppose to summarize the effects of NPL and RESERVES and should have a negative coefficient since—for this variable—higher values correspond to lower ratings. The analysis of a three-dimensional panel of sectoral data has two main advantages relative to time-series econometrics on aggregate data. First, it allows one to exploit cross-sectoral heterogeneity to identify the individual contribution of banking variables and corporate variables reducing the endogeneity problems that typically arise with time-series of aggregate data. Second, it reduces the concern about omitted variables, since the two sets of fixed effects control for any factor that does not vary simultaneously across at least two dimensions of the panel. Data Sources and Variables The Bank of Japan produces bank corporate lending series disaggregated along three dimensions: the industry of operation of the borrowing firm, the size group of the borrowing firm, and the specialization of the lending bank (Japanese banks are classified according to their type of activity and geographic coverage).7 In addition, the Bank of Japan 7See Hoshi and Kashyap (2001) for a detailed description of the various groups of banks.

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 55

conducts a quarterly survey on the conditions of enterprises in Japan (Tankan), which also contains data disaggregated by industry and firm size. Additional data on the financial condition of the banking system is compiled by Bankscope, which reports the financial statements of more than 400 Japanese banks, and the Financial Services Agency, which reports aggregate NPL figures for each group of banks. The Bank of Japan’s bank lending data are available for more than 40 economic sectors, three firm sizes, and six categories of banks (City banks, Tier-1 Regional banks, Tier-2 Regional banks, Shinkin banks, trust accounts of domestically licensed banks, and overseas branches of domestically licensed banks). Unfortunately, there are breaks in the classification of firms by size, so that consistent time series can be constructed only starting from 2000Q2.8 Furthermore, data relative to Shinkin banks is not disaggregated by borrower size and hence cannot be included in the regressions. Finally, the Tankan data on enterprise conditions, available for only a subset of industrial sectors, puts a further limit on the size of the considered sample. In the end, data availability limits the analysis to a three-dimensional panel with 23 industries, 3 firm sizes,9 and 4 categories of banks, for a total of 276 observations. The list of the sectors included in the sample is reported in Table 3.3. Descriptive statistics for the main variables in the analysis are in Table 3.4. One first important caveat concerns the matching of the Tankan data and the banking statistics data with regard to the size classification of firms. The Tankan system classifies firms solely on the basis of the number of employees. The banking statistics system instead uses both the number of employees and the firms’ capital value. However, since the two classification systems overlap with respect to the number of employees, the error introduced is likely to be only a minor one. That assumption is reinforced by the fact that the total bank borrowing series in the two datasets are strongly correlated. A second important caveat concerns the coverage of the different datasets. While the banking statistics (from which the bank credit growth data are obtained) cover the entire Japanese banking system, the Tankan survey (from which the corporate balance sheet ratio data

8Beginning April 2000, the definition of “small enterprises” was revised. See Bank of Japan (2001b) for details. 9The Tankan survey classifies firms into three groups: large enterprises (1,000 employees or more); medium-sized enterprises (300 to 999 employees); and small enterprises (50 to 299 employees). Different thresholds apply in the wholesale, retail, and services industries (see Bank of Japan (2001b) for details).

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Table 3.3. Industrial Sectors

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Ceramics, stone and clay Chemicals Communication Construction Electric and gas utilities Electrical machinery Food and beverages Industrial machinery Iron and steel Lumber and wood products Nonferrous metals Other manufacturing Petroleum and coal products Precision machinery Processed metals Pulp and paper Real estate Retailing Services Textiles Transportation Transportation machinery Wholesaling

are obtained) covers only a subset of Japanese firms. Hence, this chapter works under the assumption that the survey contains a representative sample of firms, at least with regard to the balance sheet ratios employed in the regressions. Indicators of bank financial health for each group of banks, and indicators of corporate financial condition for each industry and firm-size group, are constructed. Table 3.4. Descriptive Statistics Variable Corporate leverage Firm bank dependence (percent) NPL ratio—Bankscope (percent) Loan loss reserve ratio—Bankscope (percent) NPL ratio—FSA (percent) Loan loss reserve ratio—FSA (percent) Capital assets ratio (percent) Credit rating (1–5) Credit growth (percent)

Mean 4.6 85.1 7.0 38.7 6.4 39.3 10.3 4.25 –9.8

Standard Deviation Minimum Maximum 3.5 17.8 0.7 1.9 1.4 5.5 1.3 0.25 14.6

0.56 39.2 6.6 36.6 5.0 29.7 8.3 4.25 –46.6

15.5 99.8 8.2 41.9 8.7 44.3 11.7 4.5 22.2

Notes: Industry-fixed effects and firm-size-fixed effects are included. The coefficients for the constant and the fixed effects are not reported.

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Starting from the individual bank data contained in Bankscope, banks are divided according to their specialization, and the median values of the nonperforming to total loans ratio (NPL) and the ratio of loan-loss reserves to nonperforming loans (RESERVES) for each category of banks are computed. For robustness, alternative versions of these two variables are constructed using data published by the Financial Services Agency. Second, data from the Tankan survey is used to construct two indicators of corporate financial condition. For each industry and size group, the ratio of total debt to capital (LEVER), measuring the average degree of corporate leverage; and the ratio of bank debt to total debt (BANKDEP), measuring the average bank dependence are computed. Finally, data from the banking statistics of the Bank of Japan are used to construct bank credit growth rates for each industry and size group and for each category of bank.

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Empirical Findings Evidence from the baseline regression suggests that factors in both the corporate sector and the banking system have contributed to the aggregate credit contraction. Results are in the first column of Table 3.5 (fixed effects not reported). All coefficients have the expected sign. On the corporate side, a higher level of initial leverage is associated with a slower growth of bank credit. However, the estimated coefficient is not statistically significant. The negative effect of a higher level of bank dependence on credit growth is instead significant at the 5 percent level. On the bank side, a higher initial proportion of nonperforming loans reduces bank credit growth with a significance of 1 percent while a higher ratio of loan-loss reserves to NPLs promotes credit growth with a significance of 10 percent. The robustness of these results is tested by estimating the same model on a sample excluding the observations at the extremes of the credit growth distribution. Specifically, observations falling below the fifth percentile and above the ninety-fifth percentile of the credit growth distribution are dropped. This reduces the size of the sample to 246 observations. The results for this regression are in the second column of Table 3.5. The sign and significance of the bank dependence and the NPL coefficients are confirmed. Furthermore, the coefficient of the leverage variable is now significant. However, the coefficient of the loan-loss reserve ratio becomes statistically insignificant. A further test of the robustness of the results from the base regression is conducted by excluding, one at a time, each bank group from the estimation. This reduces the sample size to 207 observations. The results

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GIOVANNI DELL’ARICCIA

Table 3.5. Balance Sheet Ratio Regression (Bankscope)

Base

Corporate leverage Firm bank dependence NPL ratio Loan loss reserve ratio Number of observations

5–95

Excluding Excluding Excluding Tier-1 Tier-2 Excluding City Regional Regional Trust Banks Banks Banks Banks

–4.10 –5.39* –0.54 (6.8) (3.15) (8.72) –0.55** –0.27** –0.64** (0.22) (0.10) (0.28) –0.19*** –0.15*** –0.18*** (0.02) (0.01) (0.03) 0.01* –0.004 0.018 (0.007) (0.003) (0.013) 276 246 207

–9.41 –1.13 –5.32 (8.39) (5.70) (8.51) –0.77*** –0.15 –0.64** (0.27) (0.18) (0.27) –0.20*** –0.19*** 0.04 (0.02) (0.01) (0.56) 0.013* 0.01 (0.015* (0.008) (0.01) (0.009) 207 207 207

Notes: One asterisk denotes statistical significance at the 10 percent level; two asterisks, at the 5 percent level; and three asterisks, at the 1 percent level. Industry-fixed effects and firm-sizefixed effects are included. The coefficients for the constant and the fixed effects are not reported. Standard errors are in parentheses. Dependent variable is bank credit growth.

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from these tests are in Table 3.5, columns 3–6, and broadly confirm the initial estimates in this chapter. All coefficients maintain the correct sign, and in most cases maintain significance. Finally, the same model is estimated employing the NPL ratio and the loan-loss reserve ratio constructed using aggregate data from the Financial Services Agency rather than the average ratios from our Bankscope sample. The results are similar to those from the earlier regressions (Table 3.6). However, in this regression the coefficient on the NPL ratio is never significant. Balance sheet ratios are good proxies for bank health only to the extent that banks report their financial condition properly. For that reaTable 3.6. Balance Sheet Ratio Regression Bankscope ____________________ Base 5–95 Corporate leverage Firm bank dependence NPL ratio Loan loss reserve ratio Number of observations

–4.10 (6.8) –0.55** (0.22) –0.19*** (0.02) 0.01* (0.007) 276

–5.39* (3.15) –0.27*** (0.10) –0.15*** (0.01) –0.004 (0.003) 246

Financial Services Agency __________________________ Base 5–95 –4.10 (7.1) –0.55** (0.23) –0.05 (0.03) 0.03*** (0.008) 276

–5.48* (3.23) –0.26** (0.11) –0.004 (0.01) 0.02*** (0.003) 246

Notes: One asterisk denotes statistical significance at the 10 percent level; two asterisks, at the 5 percent level; and three asterisks, at the 1 percent level. Industry-fixed effects and firm-sizefixed effects are included. The coefficients for the constant and the fixed effects are not reported. Standard errors are in parentheses. Dependent variable is bank credit growth.

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son, the model is also estimated employing an alternative measure of bank health based on the market’s assessment of banks’ financial strength. In particular, the average financial strength rating by Fitch and Moody’s for each bank group is used. The assumption underlying this approach is that market analysts (and credit raters in particular) have access to information that is not wholly embedded in published bank balance sheet data. Results for this specification are in Table 3.7 and again broadly confirm those from previous estimates. Column 1 reports the results for the base regression; columns 2–6 report the results for the same battery of robustness tests as for the main model. All coefficients have the expected signs. The bank dependence coefficient is significant in all cases but one. The coefficient of the rating variable is significant in five out of six cases, and almost significant in the estimation excluding trust banks. The estimated economic magnitude of the effects of bank financial health variables on bank credit growth is substantial. For example, according to the estimates from the base regression (Table 3.5, column 1), a 1 percent reduction in the NPL ratio is associated with an increase in bank credit growth of about 1.4 percent, while a 1 percent increase in the loan-loss reserve ratio corresponds to an increase in bank credit growth of about 0.4 percent. The magnitude of the effect of a reduction in corporate leverage is more difficult to assess since the coefficient for this variable is unstable and most of the times insignificant. However, when the coefficient is significant (Table 3.6, columns 2 and 4), its effect is very large—for example, a 1 percent decrease in corporate Table 3.7. Financial Rating Regression Excluding Excluding Excluding Tier-1 Tier-2 Excluding City Regional Regional Trust Banks Banks Banks Banks

Base

5–95

Corporate leverage

–4.10 (7.5)

–5.2 (4.1)

–0.54 (8.7)

–9.41 (9.41)

–1.13 (7.13)

–5.32 (8.52)

Firm bank dependence

–0.55** (0.24)

–0.28** (0.14)

–0.64** (0.28)

–0.77** (0.30)

–0.15 (0.23)

–0.64** (0.27)

–0.40*** (0.06)

–0.21*** –0.69*** –0.45*** –0.35*** (0.03) (0.07) (0.08) (0.06)

Financial strength rating (1–5) Number of observations

276

247

207

207

207

0.11 (0.07) 207

Notes: Industry-fixed effects and firm-size-fixed effects are included. The coefficients for the constant and the fixed effects are not reported. Standard errors are in parentheses. Dependent variable is bank credit growth. One asterisk denotes statistical significance at the 10 percent level; two asterisks, at the 5 percent level; and three asterisks, at the 1 percent level.

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leverage would be associated with a 5 percent increase in bank credit growth.

Conclusions This chapter found evidence that factors in both the corporate sector and the banking system played an important role in limiting bank credit growth. According to the evidence presented, higher levels of nonperforming loans and lower levels of loan-loss reserves lead to lower bank credit growth, but higher corporate leverage and bank dependence of Japanese corporates also reduce credit growth. The policy implications of these results are straightforward and hardly surprising. The resolution of balance sheet problems in both the banking sector and the corporate sector are prerequisites for restoring self-sustaining growth.

References Atkinson, D., 2001, “Japanese Bank Asset Quality,” Goldman Sachs Global Equity Research. Bank of Japan, 2001a, “Japan’s Financial Structure: In View of the Flow of Funds Accounts,” Quarterly Bulletin, Vol. 9 (February). ——, 2001b, Financial and Economic Statistics Monthly. Bayoumi, Tamim, 2001, “The Morning After: Explaining the Slowdown in Japanese Growth in the 1990s,” Journal of International Economics, Vol. 53 (April), pp. 241–59.

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Bernanke, Ben, and Cara Lown, 1991, “The Credit Crunch,” Brookings Papers on Economic Activity: 2, Brookings Institution, pp. 205–48. Hoshi, Takeo, and Anil Kashyap, 1999, “The Japanese Banking Crisis: Where Did It Come From and How Will It End?” NBER Working Paper No. 7250 (Cambridge, Massachusetts: National Bureau for Economic Research). ———, 2001, Corporate Financing and Governance in Japan (Cambridge, Massachusetts: MIT Press). Koo, Richard, 2001, “The Japanese Economy in Balance Sheet Recession: The Real Culprit Is Fallacy of Composition, Not Complacency,” Business Economics, Vol. 36 (April), pp. 15–23. ———, 2002, “The Myth and Reality of the Japan Problem,” Nomura Research Institute. Lyons, G., 2002, “Japan—Bailing Out the Banks,” The Market Standard, March 1. Motonishi, Taizo, and Hiroshi Yoshikawa, 1999, “Causes of the Long Stagnation of Japan during the 1990s: Financial or Real?” Journal of the Japanese and International Economies, Vol. 13 (September), pp. 181–200.

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Ogawa, Kazuo, 2000, “Monetary Policy, Credit, and Real Activity: Evidence from the Balance Sheet of Japanese Firms,” Journal of the Japanese and International Economies, Vol. 14 (December), pp. 385–407. ———, and Kazuyuki Suzuki, 2000, “Demand for Bank Loans and Investment under Borrowing Constraints: A Panel Study of Japanese Firm Data,” Journal of the Japanese and International Economies, Vol. 14 (March), pp. 1–21. Peek, Joe, and Eric Rosengren, 1995, “Bank Regulation and the Credit Crunch,” Journal of Banking and Finance, Vol. 19 (June), pp. 679–92.

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Woo, D., 1999, “In Search of ‘Capital Crunch’: Supply Factors Behind the Credit Slowdown in Japan,” IMF Working Paper 99/3 (Washington: International Monetary Fund).

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CORPORATE RESTRUCTURING AND STRUCTURAL REFORMS

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4 The Resolution and Collection Corporation and the Market for Distressed Debt in Japan KENNETH KANG

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O

ver the past year, the Japanese government has outlined a strategy for addressing the nonperforming loan (NPL) problem in the banking system. The strategy calls for major banks to accelerate the disposal of nonperforming loans from their balance sheets within 2–3 years. Banks are expected to remove these loans either by selling them directly to the market, pursuing bankruptcy proceedings, or by rehabilitating borrowers through out-of-court workout procedures. Any remaining loans are to be sold to the Resolution and Collection Corporation (RCC), which under the amended Financial Reconstruction Law has been given new powers to purchase distressed assets at “fair market value” and to restructure companies. This chapter examines how the RCC can help support bank and corporate restructuring. It begins by describing the evolving role of the RCC and recent developments in the market for distressed debt in Japan. Drawing upon the experience of other countries using asset management companies, it outlines recommendations on how the RCC can play a more effective role in transferring distressed assets from the banks to the private sector. The chapter also identifies weaknesses in the framework for managing distressed assets and examines ways in which the market could be strengthened.

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Evolving Role of the Resolution and Collection Corporation

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The RCC is a government-owned agency that was originally established to collect bad loans from failed housing loan companies, banks, and credit cooperatives. It was created in April 1999 through a merger between the Housing Loan and Administration Corporation and the Resolution and Collection Bank and is financed by government bonds issued by the Deposit Insurance Corporation, which borrows from the markets and issues bonds with a government guarantee. The RCC can purchase assets under the Financial Reconstruction Account, which has available a ¥12 trillion government guarantee in FY2002. The RCC is 100 percent owned by the Deposit Insurance Corporation with ¥212 billion in subscribed capital and with about 2,400 staff members. The core operations of the RCC include: • recovery of loans transferred from former Jusen companies; • purchase and collection of NPLs from both failed and open institutions; and • pursuit of legal action to recover funds from former executives and debtors of failed institutions. The RCC’s portfolio consists mainly of real estate used as collateral on defaulted loans and to lesser extent, ordinary loans from failed institutions. During 1995 through March 2002, the RCC has acquired a total of ¥30!/2 trillion in face value loans from both failed and open institutions at a purchase price of ¥8.9 trillion. Almost all of the purchased amount was from failed institutions, including banks and former Jusen housing loan companies (Table 4.1).

Table 4.1. Assets Acquired by the Resolution and Collection Corporation, by Type (1995–end-March 2002; yen, trillions)

Assets acquired from: “Jusen” Housing Loan Companies Failed institutions based upon Deposit Insurance Law Sound banks based upon Emergency Measures for Accelerated Recovery of Market Functions Act of 1998 Total

Principal Amount

Purchase Price

Collected Amount

Collection Ratio (percent)

10.05

4.66

2.55

55

19.15

4.17

2.67

64

1.30 30.51

0.05 8.88

... 5.22

... 59

Source: Resolution and Collection Corporation.

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Under an amendment to the Financial Reconstruction Law adopted in December 2001, the RCC was given broader powers to purchase NPLs from open banks and promote corporate restructuring. Previously, because the RCC could not post losses when it disposed of its assets, it demanded steep discounts and thus was not an attractive option for banks. Under the new Law, the RCC was given more flexibility to purchase NPLs at “fair market” value and to participate directly in NPL auctions. In August 2001, the RCC was granted a trust business license to securitize nonperforming assets and issued securities of ¥107.4 billion of NPLs for the first time. The new Law also expanded the RCC’s mandate to include rehabilitating troubled companies and participating in debt-equity swaps. The RCC has come under pressure to increase its purchases of NPLs from open banks, but so far with limited success. Since the RCC is entrusted with special investigative powers that allow it to tackle difficult cases, such as real estate tied to organized crime, it has primarily served as a “catchall” for banks that have been unable to collect or sell bad loans on their own. Since its inception in 1999 through March 2002, the RCC has purchased only ¥55 billion in loans from open banks with a face value of ¥1.3 trillion (a discount of 96 percent). During January–March 2002, the RCC bought about ¥227 billion in face value loans.1 Although this is higher than last year, it is still small compared with the size of NPLs held by banks and well short of expectations.2 Although underprovisioning by banks still remains the biggest obstacle for buying these loans, the RCC is also held back from purchasing distressed assets by continuing concerns over incurring secondary losses (Figure 4.1). With its new mandate, the RCC has also taken its first steps to rehabilitate troubled borrowers and securitize distressed assets. Since establishing a restructuring unit in November 2001, the RCC has initiated restructuring programs with 14 borrowers, including three that were later sold to large creditors. The RCC also announced that it will participate in the rehabilitation of about 130 companies whose loans were bought by the RCC from failed institutions. In February 2002, the RCC participated in its first securitization of defaulted real estate loans 1Under its new mandate, the RCC is also allowed to participate directly in NPL auctions. During January–March 2002, the RCC participated in 24 auctions conducted by financial institutions, winning five bids. 2For example, in February 2002, the Liberal Democratic Party publicly called upon the RCC to purchase up to ¥2 trillion in face value loans by March 2003.

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Figure 4.1. Resolution and Collection Corporation's Record of Nonperforming Loan Purchases Under the Financial Reconstruction Law, 1999–2002 (Billions of yen) 600 Purchase price

500

Principal of claims

400 300 200 100 0

1999

2000

2001

Jan.–Mar. 2002

Source: Resolution and Collection Corporation.

(principal value of ¥107 billion) with Goldman Sachs, Mitsubishi Trust & Banking, and Asahi Bank.

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Market for Distressed Debt in Japan A market for distressed debt already exists in Japan. Although precise data are not available, market participants estimate that some ¥4–5 trillion in nonperforming assets were sold in the market last year. Initially, most of the debt sold to the market has been bilateral loans to small enterprises, collateral-backed loans, and some single-asset real estate. Much of this debt was already in bankruptcy court. However, the market for distressed debt has expanded in recent years to include securitized assets, going concerns, and direct equity purchases. Banks have reported little difficulty in setting up NPL auctions, attracting as many as 10–15 investors at any one sale including almost all of the major foreign distressed debt investors. Japanese investors have also shown interest in NPL purchases and have begun setting up their own restructuring funds (see Fiorillo, 2001). The market is considered fairly efficient, with pricing differences among competing bids having narrowed considerably. However, much of the activity remains in the primary market with very little secondary trading as most investors are end-users with a main interest in restructuring rather than trading.

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The market for securitized assets has expanded rapidly and now includes NPLs. New issuance for all asset-backed securities has increased from almost nothing in 1994 to over $25 billion in 2001 and is projected to almost double in 2002 (Morgan Stanley). The largest share comes from both commercial and residential mortgage-backed securities and consumer loans, while NPLs remain very small, accounting for about 3 percent in 2001. Interestingly, many of the end-investors in securitized NPLs are Japanese and include banks that are attracted to the floating rate exposure.3 However, the development of the distressed debt market is constrained by the lack of supply as banks remain reluctant to sell their NPLs. Most of the assets sold so far to the market have been classified as “bankrupt” or “in danger of bankruptcy,” where the required provisioning for the uncovered portion ranges from 70 percent to 100 percent. However, despite interest among investors, banks remain reluctant to part with loans classified above these categories (so-called “special attention” and above), where a company may be a going concern. At end-September 2001, loans classified as “special attention” amounted to ¥13.5 trillion for all banks. The biggest obstacle has been the underprovisioning of problem loans by banks, which leads to large gaps in pricing. Other difficulties include insufficient capital to absorb further losses, banks’ close relationship with their borrowers, and expectations that collateral values will rise with an economic recovery. Low interest rates have also reduced the carry costs of these loans. Investors also face other obstacles to purchasing NPLs from banks. Insufficient disclosure on the debtor and difficulties in crystallizing claims on collateral have complicated sales and made pricing difficult. Investors have reported that banks have been reluctant to share information about their borrowers when looking to sell their claims, particularly for loans where the borrower is still a going concern and retains a close relationship with their main bank.4 In addition, buyers have reported difficulties in transferring titles and receiving the borrower’s consent for collateral sales. Although these obstacles are surmountable, they create delays and lead to large pricing gaps. Investors have also 3For example, in November 1999, Morgan Stanley Dean Witter issued the International Credit Recovery—Japan One, a $200 million fund representing the first NPL securitization in Japan. The securitized asset consisted of nonperforming commercial mortgage loans and real estate properties purchased from various Japanese financial institutions and real estate companies. The issue received a AAA rating on its senior tranche and offered a fixed spread over LIBOR (35 to 200 basis points). Sixty-two percent of the investors were from Asia, including many banks. 4Information disclosure on NPLs is not formalized as syndicated lending, for example, is in other markets.

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noted “vacant possession problems” associated with collateral, particularly with those linked to organized crime, and high transaction taxes and registration fees that reduce turnover in the market. The lack of a secondary market for distressed debt has also turned away potential portfolio and other fund investors from the market. Banks also face some uncertainty on the balance sheet treatment of their NPL sales, particularly if they retain some residual exposure to the final sale. The accounting guidelines are unclear on NPL sales involving profit sharing or debt-equity swap arrangements where the bank may retain some upside potential from the final sale. As a result, banks may not be able to complete a “clean sale” and realize the tax benefit from their loan losses. Other difficulties include the lack of clear rules governing the valuation of converted equity in a debt-equity swap and corporate governance difficulties in working with shareholders in an out-of-court workout framework.5 Intercreditor issues are also a problem, as minority creditors may be wary of the involvement of the main bank in negotiating a debt restructuring agreement or sales to outside investors. However, it should be noted that these difficulties are secondary to the larger problem of underprovisioning of problem loans.

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Role of the Resolution and Collection Corporation in Bank and Corporate Restructuring Asset management companies have been used in a number of countries to take over the nonperforming assets of failed financial institutions and to support corporate restructuring (Ingves and Lind, 1996; Ingves, 2000). By transferring these assets off the banks’ balance sheets and disposing of them quickly, these asset management companies have helped to restore the liquidity and solvency of weak financial institutions and confidence in the system as a whole. Asset management companies have also been used to create a market for distressed debt by ensuring a steady supply, stabilizing prices, and setting standards for transactions. Also, by securing a high rate of recovery, asset management companies can help to reduce the burden on taxpayers from the use of public funds. In some cases, asset management companies have 5For example, in some debt-equity swaps, banks have valued the converted equity at its nominal value (that is, no write-down), while in other cases they have marked them to market. The issue became even more clouded in 2001, when the Tokyo District Court ruled in one case that a bank could value its converted equity at nominal value. In June 2002, the Accounting Standards Board of Japan announced that it will introduce new guidelines for debt-equity swaps by the spring of 2003.

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participated directly in corporate restructuring, though often with the involvement of the private sector. Cross-country experience with centralized asset management companies suggest that they are better suited for rapid asset disposal than for corporate restructuring. Klingebiel (2000) examines the experiences of seven countries with asset management companies following a banking crisis.6 The evidence demonstrated that the most successful asset management companies were those with narrowly defined mandates. Asset management companies set up for rapid asset disposal, such as in Spain and the United States, performed better than those used for corporate restructuring. Restructuring agencies had a mixed record and were constrained by the difficulties in handling many different types of NPLs, which complicated wholesale disposal and required the buildup of expertise in many areas. Sweden is the exception and was successful both as the lead agent in restructuring of real estate and construction loans and in the rapid disposal of nonperforming assets. The RCC could help promote corporate restructuring, but its portfolio of mainly real estate collateral and its limited resources and experience suggest it should focus on asset disposal and leave the lead role in corporate restructuring to the private sector. As banks continue to make progress in disposing of their bankrupt loans, the growth area is likely to be the market for restructuring “need attention” borrowers where the debtor is still a going concern. The RCC could support the restructuring of viable but distressed firms through joint ventures with professional workout specialists where the RCC takes a minority position (for example, with Development Bank of Japan funding). Equity partnerships would help improve recovery prospects by bringing in outside expertise and leveraging the interests of private investors. However, having the RCC as the lead agent for restructuring runs the risk of distorting commercial decisions and inviting political interference, potentially leading to the warehousing of assets, slower restructuring, and further losses.7 6They include asset management companies used as rapid disposal vehicles in Mexico (1994), the Philippines (1981–86), Spain (1977–85), and in the United States (1984–91); and asset management companies used as restructuring agencies in Finland (1991–94), Ghana (1982–89), and Sweden (1991–94). 7Expectations for the RCC to play a similar role as other centralized asset management companies in taking over and restructuring banks’ NPLs may not be realistic. Unlike in other countries where asset management companies were introduced in the midst of a financial crisis to manage the assets of failed institutions, the RCC has been called upon to act as a receiver of assets from failed institutions and as a direct buyer of NPLs from open banks. Also, as noted earlier, an active market for distressed debt already exists in Japan.

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The RCC should look to expand the market for distressed debt by purchasing NPLs from banks and disposing of them quickly to the private sector. The RCC is entrusted with special powers that are not available to the private sector, allowing it to play a useful role even if it only acts as a broker in the market. By transferring nonperforming assets to the private sector, the RCC could help expand the market for distressed debt, clean up banks’ balance sheets, and accelerate the reallocation of resources in the economy. At the same time, the RCC should look to quickly dispose of assets already on its books from both failed and open banks, using a strategy that takes into account the cost of its capital and depreciation of its assets. Specifically, the RCC could do the following. • With its special investigative powers, the RCC could take on difficult assets that other investors are unwilling to touch, free them of their impediments, and sell them back to the market. The RCC could also use its legal powers to recover liabilities from managers or owners who have engaged in illegal or fraudulent activity. • The RCC can help crystallize claims on collateral subject to multiple liens. When a collateralized loan is transferred, its priority claims need to be established which can sometimes be a costly and difficult process. When the RCC purchases assets, it is exempt from seeking the approval of the borrower or other lien holders for transferring the title of the asset. By bypassing this difficult step, the RCC can “clean up” difficult assets with multiple claims by crystallizing its claim and ready it for quick sale back to the market—a power not available to the private sector. • The RCC can help resolve intracreditor disputes and strengthen the leverage of creditors in negotiating with debtors. By buying up multiple credits and selling them to a single party, the RCC could help promote restructuring by securing a main creditor position against a debtor. This would also facilitate debt restructuring and equity swaps by avoiding intracreditor disputes over pricing and debt write-offs. As a participating creditor, the RCC could also mediate disputes among creditors helping them to reach an outof-court agreement on a debt restructuring plan. • The RCC can also help expand the market for securitized NPLs. As is done in other countries, the RCC can assist investors in purchasing various credits and repackaging them for sale as a securitized asset. With its trust license, the RCC can also set up special-purpose vehicles that can issue and service securitized assets. By establishing pricing benchmarks and standards for securitized transactions, the RCC can help develop the market for NPL

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securitized assets, similar to what the RTC did in the United States in the 1980s. In addition to direct sales, securitization could be another tool for banks to remove their NPLs and expand their investor base to include portfolio and other investors. • The RCC can improve the transparency of the NPL market by setting standards for disclosure and publishing information on various assets, including on its own portfolio. Insufficient disclosure on debt conditions has lead to large pricing gaps between buyers and sellers. By setting high standards for its own disclosure and encouraging others to follow suit, the RCC can improve the flow of information in the market and help reduce uncertainty over asset quality. • The RCC can help sever unhealthy ties between main banks and their distressed corporate borrowers. In instances where the main bank may have a long-standing relationship with the borrower, it may be reluctant to sell its problem loans out of fear of damaging its trust relationship and reputation. By buying these loans and selling them to another party, the RCC can help sever those close ties that impede restructuring and improve the chances for loan recovery.

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Specific Recommendations for Strengthening the Resolution and Collection Corporation Based upon the experience of asset management companies used in other countries, this section outlines specific steps for strengthening the role of the RCC in purchasing and disposing of banks’ nonperforming loans. Experience has shown that asset management companies were more effective in carrying out their functions if they were given a clear mandate and possessed a governance structure that supported their operations. Mandate of the Resolution and Collection Corporation For the RCC to operate effectively, its public mandate should include not just collection but also maximizing recovery within a fixed period of time. To help the RCC move away from its historical role as a collection agency and enhance its commercial orientation, the government should give the RCC the clear mandate to manage its assets with the objective of maximizing recovery within a fixed period of time (e.g., within two years upon purchase). This would also help expedite

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the disposal of assets already on its books. Attaching objectives outside the RCC’s core mandate, such as recapitalizing banks through the transfer of overvalued assets or assisting in the revitalization of distressed firms, runs the risk of undermining its effectiveness at achieving its main purpose.

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Purchase Price and Asset Selection The RCC’s mandate to purchase NPLs at realistic and fair market prices is appropriate. Market valuation promotes transparency and creates the right incentives for the RCC and banks to restructure loans or to seek out bankruptcy or liquidation procedures. Some have called for the RCC to purchase impaired assets at above-market prices as a way of encouraging banks to part with their nonperforming assets. Although purchases at a higher-than-market price—for example, net book value—would make it more attractive for banks to sell to the RCC, it would send the wrong signal to banks, rewarding those that have made less progress in recognizing loan losses and encourage inadequate provisioning. “Backdoor” recapitalization also hides the true cost of public funds and may undermine the commercial goal of the RCC. To encourage banks to part with their impaired assets, the RCC could explore the use of profit-sharing arrangements. This would allow banks to share in any upside potential and avoid potential criticism of selling assets at fire sale prices.8 Given the difficulty in pricing nonperforming assets, profit-sharing arrangements may also help accelerate NPL sales and narrow the pricing gap by allowing banks to avoid lengthy haggling over pricing issues. Other ways to entice banks to sell would include allowing banks to retain a portion of the equity following a debt-equity swap or to hire banks as the servicing agent for the loan. The requirement of prime ministerial approval for the pricing of individual NPLs should be lifted. Although this responsibility has been operationally delegated to the Financial Services Agency and approval has so far been smooth, the requirement of prime ministerial approval limits the flexibility of the RCC to adjust its prices quickly during negotiations. The requirement of prime ministerial approval also runs the risk of outside interference, particularly over assets that may be considered politically sensitive. Granting the RCC more independence in its decision making and allowing it to operate at “arm’s length” from other government ministries 8For example, Danaharta in Malaysia incorporated profit sharing in some of their contracts, which allowed banks to retain 80 percent of any profit realized from the final sale.

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would help the RCC to be more effective at asset disposal and raise its credibility with the markets.

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Asset Management and Disposal To ensure against the warehousing of assets, the RCC should adopt a well-defined strategy for disposing of its assets that takes into account the cost of its capital. Other asset management companies have adopted clear and simple strategies to maximize recovery and protect against losses in disposing of their assets. They include the following. • Sweden’s Securum adopted a simple rule that real estate would be sold if the projected property price increase was less than the real cost of holding onto the assets. This method resulted in rapid disposal of assets (98 percent in 5 years), helping the agency to conclude its operations 5–10 years ahead of schedule (Ingves and Lind, 1996; Ingves, 2000). • The main goal of the U.S. Resolution Trust Corporation was to maximize the return and minimize the loss of the assets it had acquired from failed savings and loans institutions. It adopted a net present value approach that helped avoid the warehousing of assets and reinforced the important notion of the time value of money. The Resolution Trust Corporation was set up in 1989 and finished operations in 1995, one year earlier than planned, and recorded an overall recovery rate of 87 percent (FDIC, 1998). • In Korea, the Korea Asset Management Company (KAMCO) was a centralized asset management company organized in 1997 to manage the disposal of nonperforming assets acquired from both failed and open financial institutions. Between 1997 and March 2002, it purchased $31 billion in nonperforming assets at a face value of $81 billion. KAMCO used a variety of methods to dispose of its assets including auctions, outright sales, equity partnerships and securitization. KAMCO announced that it would cease purchases in November 2002 and sell its remaining assets within two years. A simple rule whereby assets are sold if the estimated return after restructuring falls below its carry cost using a real discount rate linked to the RCC’s cost of capital (i.e., the interest rate on Deposit Insurance Corporation–issued bonds) could be applied to the RCC’s entire portfolio. Although in the current low-interest rate environment the nominal carry cost may be low, the real cost is much higher after accounting for continued deflation and depreciation. Based upon this simple rule, real estate and other assets with high rates of depreciation should be

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sold first. To enhance its accountability, the RCC should adopt timebound performance targets for disposing of its assets and conduct a review of its loan portfolio. These targets could include face value amounts to be sold and methods for disposal (for example, by auction or securitization). To be more flexible, the RCC should focus on the return of its overall portfolio and not on returns on individual transactions. This would encourage the RCC to cut its losses on assets where the recovery prospects are minimal and instead shift its resources to assets that have greater potential for recovery. To boost returns and strengthen its activities, the RCC should end its practice of passing earned profits back to companies in the form of debt waivers and instead use these earnings to restructure or invest in assets. Separating the RCC’s performance under its new mandate from its old collection responsibilities may free the RCC from the burden of previous losses on assets that may have been acquired from failed institutions at overvalued prices.9

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Organizational Structure and Governance To be effective, an asset management company should have a governance structure that supports its stated mandate. Asset management companies should be transparent and independently operated, and possess an incentive structure consistent with their goals. Outside interference in the operations of the asset management companies, such as in the selection and pricing of assets, runs the risk of undermining its credibility and commercial orientation. Cross-country experience has shown that asset management companies with clearly defined goals and supporting governance structures are more effective in carrying out their functions. The RCC would benefit from having greater operational independence. In addition to removing the requirement for prime ministerial approval on pricing decisions, the government should consider other ways of enhancing the RCC’s independence and protecting it from political pressures, particularly from vested interests. One way would be to appoint outside directors from the private sector to serve on the RCC’s board; these outside directors could also bring valuable restructuring experience to strengthen the RCC’s function. Another possibility would be to adopt a holding company structure as was done in Sweden, with 9However, initially, the RCC may wish to accept lower returns and dispose of assets quickly to jumpstart the market for NPLs. This may mean accepting lower rates of return at first, to demonstrate that money can be made by both banks and investors and expand the market.

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different units specializing in particular asset types and disposal activities, or to make the RCC an independent entity separate from other government agencies with its own operating budget. The government would still be the sole owner and shareholder but, compared with other agencies, the RCC would have more independence and latitude in fulfilling its mandate. The RCC should improve its transparency and disclosure. Greater transparency of the RCC’s operations would help promote directorial and managerial accountability. In addition to its annual financial statements, the RCC should publish regular reports describing its progress in meeting its benchmark targets as well as general information on its portfolio.10 Its financial statements should be published (including on the Internet), and an internal audit procedure should be put in place. The RCC should utilize the help of the private sector in restructuring nonperforming assets. Given its history as a collection agency and experience mainly with real estate assets, the RCC could benefit from the experience of private sector restructuring experts in the pricing and disposition of nonperforming assets.11 As banks look to sell different types of assets, including those as going concerns, and the market for distressed debt expands, the RCC will need to build up the necessary expertise to keep up with changes in the market. Finally, to ensure against the warehousing of assets, the RCC should consider announcing a time limit for its operations. If ultimately successful, the RCC should no longer need to exist in its present form. Other asset management companies, such as in the United States and Sweden, announced at the outset deadlines for their eventual liquidation. A time-bound limit would also encourage banks to use the RCC as quickly as possible to dispose of their unwanted assets. Over time, the activities of the RCC could be sold back to the private sector, allowing the RCC to eventually return to its original function of managing the distressed assets of failed financial institutions. Strengthening the Market for Distressed Debt Apart from the RCC, a number of other complementary reforms are needed to strengthen the market for distressed debt. Looking ahead, it is likely that banks will begin to look more to the private market (and 10For example, the RCC should publish information not only on collection, but also on the recovery rates on its resolved assets—to emphasize its commercial orientation. 11The U.S. Resolution Trust Corporation also relied predominantly on private sector firms to evaluate and market its loan portfolio, which boosted the credibility of its valuation methodology (FDIC, 1998).

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KENNETH KANG

the RCC) for help in handling their nonperforming assets.12 To ensure that these assets are handled properly, the government should look for ways to strengthen the framework for managing distressed assets and ensure that the right incentives are in place for meaningful restructuring. To address some of the weaknesses described earlier in the paper, the following steps could be taken to strengthen the market for distressed debt. Any tax obstacles to the transfer of NPLs should be removed. For example, the government should clarify the tax treatment on losses arising from debt-equity swaps or NPL sales and remove any tax impediments that may hinder banks from selling or transferring their NPLs. Conditions for obtaining the borrower’s consent for collateral sales should be eased. Although this has not been a problem for investors purchasing loans to bankrupt borrowers, investors reportedly face difficulties in transferring title ownership on collateral when the owner is still a going concern and has maintained a close relationship with its bank. Easing the conditions for selling collateral and further clarifying the distribution of collateral rights would help raise turnover in the real estate market and facilitate the transfer of nonperforming assets from the banks. The regulatory and accounting framework for conducting debtequity swaps and setting up asset management company subsidiaries should be strengthened. In particular, the guidelines for valuing converted equity in a debt-equity swap should be clarified. To create the proper incentives for restructuring, converted equity should be valued conservatively and any debt transferred to an asset management company subsidiary should be marked-to-market. Allowing banks or other financial institutions to transfer debt at nominal values or to convert equity at overvalued prices runs the risk of hiding losses, overstating capital, and reducing the incentives for restructuring. Greater transparency and disclosure would help expand the market and improve pricing. Insufficient disclosure by borrowers and by creditors, particularly on asset quality, to potential buyers has led to pricing difficulties, adding to the premium in the market. Greater disclosure on debt conditions would reduce the need for lengthy due diligence, improve price discovery, and encourage more investors to come into the market.

12For example, banks reportedly have expressed interest in establishing asset management companies with private investors to manage their own distressed assets.

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References Federal Deposit Insurance Corporation, 1998, “Managing the Crisis: The FDIC and RTC Experience 1980–1994” (Washington: FDIC). Fiorillo, James, 2001, “Evolution of the Distressed Debt Market: Frozen Solid; Few Participants” (Tokyo: ING Barings). Ingves, Stefan, 2000, “The Role of Asset Management Companies in Bank Restructuring,” paper presented at November 2000 NPL Forum of Asia-Pacific (Washington: IMF). ———, and Goran Lind, 1996, “Loan Loss Recoveries and Debt Resolution Agencies: The Swedish Experience” in Banking Soundness and Monetary Policy, ed. by Charles Enoch and John Green (Washington: International Monetary Fund), pp. 421–42.

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Klingebiel, Daniela, 2000, “The Use of Asset Management Companies in the Resolution of Banking Crises: Cross-Country Experiences,” World Bank Policy Research Working Paper No. 2284 (Washington: World Bank).

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5 Structural Reforms, Information Technology, and Medium-Term Growth Prospects TIM CALLEN AND TAKASHI NAGAOKA

Based on the belief that the top priority of the Koizumi Cabinet is the revitalization of the economy and that ‘without structural reform, there can be no rebirth for Japan,’ we will tackle structural reforms, leaving no sacred areas exempt from these reforms.

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Extract from Prime Minister Koizumi’s speech at the Eighth Meeting of the Council on Economic and Fiscal Policy, May 18, 2001.

T

he government of Prime Minister Koizumi has stated its intention to implement a bold reform agenda to return Japan to strong, sustained growth over the medium term. Addressing banking sector weaknesses, fiscal reforms, and structural reforms that boost productivity are at the top of the agenda. The experience in a number of faster-growing industrial countries in recent years certainly underlines the importance of implementing a far-reaching structural reform agenda in Japan. Given that productivity levels in many sectors of the Japanese economy are well below international best standards, there appears to be considerable scope for raising productivity over the medium term. Indeed, Economics Minister Takenaka has suggested that the full implementation of the reform blueprint set out by the Council on Economic and Fiscal Policy could raise potential growth to 2–3 percent over the medium term, compared to staff estimates of about 1 percent at present. A number of empirical studies have also estimated that considerable output gains would result from the implementation of structural re80

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forms. While the reform program will need to be broad-ranging to maximize its economic benefits, this paper focuses on four areas that are particularly important: the labor market; entrepreneurship; the regulatory structure and competition policy; and the information technology (IT) sector.

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Benefits of Structural Reforms in Japan A number of competing hypotheses have been advanced to explain the extended period of subpar growth in Japan during the 1990s (see Bayoumi and Collyns, 2000, and Boltho and Corbett, 2000, for concise summaries). Among recent contributions, Hayashi and Prescott (2002) argue that the primary reason for weak growth has been a sharp decline in productivity growth, possibly because of the increasing failure of the traditional Japanese model to adapt to the requirements of a more deregulated and competitive world economy. It is clear that the decline in productivity growth during the 1990s was significant. Total-factor productivity growth in the business sector is estimated to have been about #/4 percent a year, about one-half of the rate experienced in the 1980s, while labor productivity growth slumped from 2#/4 percent in the 1980s to 1#/4 percent in the 1990s (Table 5.1). Scarpetta and others (2000) found that the decline in labor productivity growth in the nonfarm business sector during the 1990s was largely the result of lower productivity growth in the manufacturing, construction, wholesale and retail, and finance sectors (although, during the decade, the manufacturing sector accounted for almost all of the productivity growth that took place). The decline in labor productivity growth in Japan is in contrast to most other countries in their study, where it increased during the 1990s because of modest improvements in the service sector. Scarpetta and others (2000) disaggregated labor productivity growth into three components: changes in within-industry productivity performance; the impact of the shift of resources between different industries; and residual effects. They estimated that during the 1990s most of the change in labor productivity growth in OECD countries was due to productivity performance within industries, rather than employment shifts across industries. The role of resource shifts between sectors was found to be more important during the 1970s and 1980s. These broad results are true for Japan, although resource shifts between sectors have been less important historically in Japan than in most other countries. Looking at aggregate labor productivity levels, Scarpetta and others (2000) found that Japan lags significantly behind most other OECD

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3.1 4.0 2.3 2.3 2.5 3.0 2.8

3.3 2.5 1.6 1.7 1.7 2.1 2.5

3.8 2.2 1.7 1.8 1.7 2.3 3.1

2.0 1.3 0.5 –0.2 0.5 0.6 1.7

2.0 1.3 0.5 –0.2 0.5 0.6 1.7

2.0 1.3 0.5 –0.2 0.5 0.6 1.7

1.1 2.7 1.8 2.4 2.0 2.3 1.1

1.4 1.8 2.1 1.7 2.3 1.5 1.1

1.6 1.9 2.0 1.6 2.3 1.6 1.1

1.1 4.9 2.9 2.3 2.7 1.8 1.8

0.6 4.7 3.7 2.3 3.5 1.2 0.9

Source: Scarpetta and others (2000). 1GDP per employee. 2Growth of capital/labor ratio, adjusted for hours worked. 31990–97 for Italy and Japan, 1990–96 for the United Kingdom, and 1991–98 for Germany. 41995–97 for Italy and Japan, and 1995–96 for the United Kingdom. 51990–97 for Canada, Italy, Japan, and the United States; 1990–96 for United Kingdom, and 1991–98 for Germany. 61995–97 for Canada, Italy, Japan, and the United States; and 1995–96 for the United Kingdom. 7West Germany for 1980–90.

United States Japan Germany7 France Italy United Kingdom Canada

1.0 4.4 3.1 2.3 3.4 1.0 1.4

0.8 1.6 1.1 1.6 1.2 ... 0.3

1.1 0.7 1.0 0.9 1.1 1.2 0.7

1.1 0.8 1.1 0.8 0.9 1.3 0.7

1980–90 1990–983 1995–984 1980–90 1990–983 1995–984 1980–90 1990–983 1995–984 1980–90 1990–985 1995–986 1980–90 1990–985 1995–986



GDP Employment Labor Productivity1 Capital Deepening2 Total-Factor Productivity ______________________ _____________________ _____________________ ______________________ _____________________

(Percent change at annual rate)

Table 5.1. Summary of Business Sector GDP Growth and Its Components

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82 TIM CALLEN AND TAKASHI NAGAOKA

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countries (Table 5.2). In the manufacturing sector, this differential is somewhat smaller, although still significant. The McKinsey Global Institute (2000) found that while productivity levels among Japan’s manufacturing exporters—particularly in the automobile, steel, machine tools, and consumer electronics sectors—exceed those in the United States by about 20 percent, in the domestic manufacturing and service sectors productivity is significantly below U.S. levels. Assessing the potential impact of structural reforms on productivity and economic growth is difficult because of the problems of measuring the impact of current regulations on economic performance and of establishing appropriate benchmarks for the postreform economic structure. However, a number of attempts have been made to quantify such impacts on the Japanese economy, although the results are very sensitive to the underlying assumptions made. Shimpo and Nishizaki (1997) reported that most studies found that reforms would have a significantly positive impact on real GDP, although the size of the estimated gains varied considerably from 2!/4 to 18#/4 percent of GDP. The estimate

Table 5.2. Productivity Levels in OECD Countries, 1950–98

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(Percent change at annual rate) 1950

1960

1973

1987

1992

1998

100 15 34 ... 42 38 58 68

100 20 52 ... 51 46 57 72

100 45 73 ... 74 78 68 75

100 60 91 ... 99 96 81 83

100 67 100 87 101 97 79 82

100 68 106 90 102 100 82 80

Australia Belgium Denmark Finland Greece

66 50 54 32 19

68 53 58 37 ...

69 76 79 59 43

77 102 85 69 55

75 108 85 74 54

78 109 89 82 54

Ireland Korea Mexico Netherlands Norway

32 11 35 49 51

... ... ... 57 ...

46 15 47 82 71

66 25 ... 98 96

77 32 41 107 104

86 36 34 98 109

Portugal Spain Sweden Switzerland

20 24 50 70

... ... 55 74

42 53 78 84

44 79 84 85

48 80 82 87

50 79 84 85

United States Japan West Germany Germany France Italy United Kingdom Canada

Source: Scarpetta and others (2000).

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TIM CALLEN AND TAKASHI NAGAOKA

made by the Economic Planning Agency (1994) was in the middle of this range at 8 percent. A more recent study by the Ministry of International Trade and Industry and the Sanwa Research Institute (2000), however, found a much larger impact, with real GDP growth estimated to be 2!/2 percent a year higher for 10 years. This larger estimate of the potential gains is due to the authors’ attempt to include the impact of IT diffusion and the creation of new markets on the economy, which accounts for 1!/2 percent of the estimated annual increase. In a study of major industrial countries, the OECD (1997) estimated the impact of reforms on a broad range of economic variables based both on the aggregation of the estimated gains in a number of key sectors and on simulations of a dynamic macroeconomic model. The results suggest that the long-run potential output gains (over a period of 15 to 20 years) in Japan are on the order of 5–6 percent, broadly in line with those in France, Germany, and Spain, and well above the 1 percent estimate for the United States. A significant part of the potential productivity gains in Japan was found to come from reform of the distribution sector. An alternative approach to the simulations used in the studies cited above is to relate broad indicators of regulation to economic performance. Porter (1998) used a survey of business leaders and government officials to construct a microeconomic competitiveness index and found that this index was a significant explanatory factor in standard cross-country growth regressions. Similarly, Dutz and Hayri (2000) used a wide range of variables that attempt to capture competition policy, market structure, and enterprise mobility (entry and exit of firms) in different countries, and again found that such variables are significant explanatory factors in standard cross-country growth regressions. In terms of the indices that have been constructed to measure structural rigidities or competitiveness, Japan fairs relatively poorly. These indicators generally suggest that structural rigidities in the Japanese economy significantly exceed those in the faster growing industrial countries, although they are in line with many of the euro area countries (Table 5.3; Figure 5.1). For example, in Porter’s Microeconomic Competitiveness Index, Japan ranks eighteenth out of the 52 countries considered (sixth out of the G-7 countries, ahead of only Italy), while in the Lehman Brothers Structural Policy Index, Japan ranks twelfth out of the 21 OECD countries (see Edwards and Schanz, 2001). Broader indicators of world competitiveness published by the International Institute for Management Development and the World Economic Forum that combine a wide range of macroeconomic and microeconomic variables with the results of surveys of businesses yield similar conclusions.

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Taiwan Province of China Israel Spain Chile Iceland South Africa Italy

20

Italy Greece ... ... ... ...

Portugal

Japan ... ... ... ... ...

New Zealand

Israel

New Zealand Estonia Spain Chile France Japan

Norway

Germany Iceland Austria Denmark Israel Belgium Taiwan Province of China United Kingdom

United States Singapore Finland Luxembourg Netherlands Hong Kong SAR Ireland Sweden Canada Switzerland Australia

49

2001

. . . . .

France .. .. .. .. ..

Taiwan Province of China Austria

Germany New Zealand Belgium Denmark Japan Iceland Ireland

United States Singapore Netherlands Finland Hong Kong SAR Norway Sweden Australia United Kingdom Switzerland Canada

...

...

Ireland ... ... ... ... ...

Japan

Singapore

Denmark Spain Israel Finland Sweden Belgium France

Brazil Korea United States Australia Norway Canada Argentina India Italy United Kingdom Germany

21

2000

Hungary ... ... ... ... ...

Taiwan Province of China Japan

Canada Singapore Thailand Australia Czech Republic Korea Netherlands

United States China Brazil United Kingdom Mexico Germany India Italy Spain France Poland

25

...

FDI ______________ A.T. Kearney Foreign Direct Investment Confidence Index

Pakistan ... ... ... ... ...

Taiwan Province of China Brazil

Peru Egypt Lithuania South Africa Japan Colombia Argentina

Singapore United States Chile United Kingdom Hong Kong SAR Mexico Italy Hungary Israel Uruguay Greece

...

...

Price Waterhouse Coopers Opacity Index

Transparency ______________

Source: International Institute for Management Development; Babson College; Edwards and Schanz, 2001; and partly reproduced from Deutsche Bank Foreign Exchange Research, April 2001.

21 22 23 24 25 26

Belgium

19

Austria

Japan France Norway Germany Belgium Euro area Spain

Hong Kong SAR Ireland Norway Australia Austria New Zealand Japan

12 13 14 15 16 17 18

...

22

United States Singapore Luxembourg Netherlands Ireland Finland Canada Hong Kong SAR United Kingdom Switzerland Taiwan Province of China Australia Sweden Denmark Germany Norway Belgium Austria

2000

Entrepreneurship _______________ Babson College International Institute Global World Economic for Management Japan Center for Entrepreneurship Forum Development Economic Research Monitor

Global Competitiveness _________________________________________________

1999

United States Canada New Zealand United Kingdom Australia Sweden Switzerland Ireland Finland Netherlands Denmark

52

1999

Lehman Brothers Structural Policy Index

Structural Policy ______________

Ranking 1 United States 2 Finland 3 Netherlands 4 Germany 5 United Kingdom 6 Canada 7 Sweden 8 Denmark 9 Switzerland 10 Singapore 11 France

Year Countries surveyed

Microeconomic Competitiveness ______________ Porter’s Microeconomic Competitiveness Index

Table 5.3. Surveys of Global Competitiveness

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86

TIM CALLEN AND TAKASHI NAGAOKA

Figure 5.1. Product Market Regulation and Per Capita Real GDP Growth in OECD Countries Average per capita real GDP growth over 1996–2000; percent 10

8

6

4

USA

UK

2

AUS

JPN

0

0

more flexible

0.5

1.0

1.5

2.0

Product market regulation

2.5

more rigid

Sources: Nicoletti, Scarpatti, and Boyland (2000); and IMF staff estimates.

Structural Reforms to Raise Productivity Growth

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The results of these empirical studies and the analysis of crosscountry productivity data suggest that considerable benefits could accrue to the Japanese economy from the implementation of a bold and broad-ranging structural reform program. This section looks in more detail at areas where reforms could yield particularly significant benefits. Labor Market The flexible labor market in the United States has been an important aspect of its strong economic performance during the 1990s and the rapid spread of new technologies and production techniques (Council of Economic Advisors, 2001). Labor market flexibility encompasses both workers with desirable skills being able to switch to more rewarding jobs and firms being able to adapt their work force to changing economic conditions. It is particularly important in hightechnology industries where the pace of innovation and industry evolution is especially rapid. However, a number of indicators suggest that while labor compensation is quite flexible over the business cycle, the Japanese labor market is not very efficient at reallocating labor between firms and across sec-

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tors. The inability or reluctance of firms to adjust their labor force appears to have been an important factor behind the decline in productivity growth during the 1990s. The concurrent increase in the unemployment and vacancy rates since the mid-1990s, as seen in the outward movement of the Beveridge curve, and the rise in the structural unemployment rate indicate an increasing mismatch in the labor market (Figure 5.2).1 The proportion of those unemployed for over one year in total unemployment has also risen from 15 percent in 1993 to over 30 percent in early 2002. Significant mismatches between the supply and demand for labor in key industries also underscores the failure of the market to reallocate labor (Figure 5.3). From an international perspective, Japan has one of the least mobile workforces in the OECD. For example, labor turnover (which measures the movement of individuals into and out of the workforce) in Japan is about half that in France and Germany and about one-fifth that in the United States, while the average job tenure of men in Japan is the longest among large OECD countries (job tenure of all employees is slightly below that in Italy because of the shorter average tenure of women) (OECD, 1997). (See Table 5.4.) Genda and Rebick (2000) find that there is a high rate of job-changing among Japanese under the age of 30 but then the proportion who settle into long-term jobs is very high. A number of features of the Japanese employment system help explain the relatively low degree of labor mobility. Among the most important are the practices of “lifetime employment” and seniority-based wages, which act as disincentives for workers to change jobs (underpayment in early years of work is expected to be compensated for in the future, and workers are therefore inclined to stay with a firm until their intertemporal wages are balanced) and for firms to hire older workers.2 Firm-specific knowledge acquired through on-the-job-training—another feature of the lifetime employment system—has also tended to make skills less transferable to other firms. Widely shared social stigma toward losing jobs and/or being jobless has also induced incumbents to remain in their positions and not risk changing jobs, while pension schemes designed for traditional employment practices have lacked portability (although the introduction of defined contribution pension schemes in October 2001 may help to address this over time).

1The

structural unemployment rate is estimated to have risen from about 2 percent in the early 1990s to 4 percent in early 2002 (Ministry of Health, Labour, and Welfare). 2The term “lifetime employment,” which describes the “implicit long-term employment contract for the regular workforce” (Kato, 2001), may be misleading as most workers leave firms before reaching legal retirement age (Genda and Rebick, 2000).

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TIM CALLEN AND TAKASHI NAGAOKA

Figure 5.2. Developments in Structural Unemployment Unemployment rate (percent) 6.5 Beveridge Curve1 6.0 00Q1 5.5

01Q1

Structural / frictional adjustment

99Q1

5.0 98Q1

4.5 96Q2

4.0

Cyclical adjustment 97Q1

95Q2

3.5

85Q1

3.0 2.5 2.0

1.5

2.0

2.5

3.0

4.0

3.5

Vacancy rate (percent) Unemployment rate (percent) 6 5

Total

4 3 Structural/frictional

2

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1

Cyclical

0 –1

1985 86

87

88

89

90

91

92

93

94

95

96

97

98

99 2000 01 02

Sources: Ministry of Public Management, Home Affairs, Posts, and Telecommunications; Ministry of Health, Labour and Welfare; and IMF staff estimates. 1Definition of the unemployment rate here excludes the self-employed from the workforce.

Other institutional factors have also been important in impeding labor market flexibility. Japanese employees enjoy high levels of protection from dismissal, both because trade unions have put employment protection ahead of wage gains and because labor laws are strictly interpreted. While the employment protection legislation itself is relatively liberal, and dismissing employees is a basic right of employers,

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Figure 5.3. Labor Sufficiency (Percent) Wholesale and retail

Construction

Electrical machinery

All industries

50 40 30 20 10 0 –10 –20 –30 –40 –50 –60 –70

Sufficiency of Labor (Excess minus shortage of labor)

1990

91

92

93

94

95

96

97

98

99

2000

01

93

94

95

96

97

98

99

2000

01

50 Excess of Labor

45 40 35 30 25 20 15 10 5 0

1990

91

92

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80 70

Shortage of Labor

60 50 40 30 20 10 0

1990

91

92

93

94

95

96

97

98

99

2000

Source: Bank of Japan, Tankan Survey. Note: Indices indicate the proportion of firms that responded that they had excess (insufficient) labor.

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TIM CALLEN AND TAKASHI NAGAOKA

Table 5.4. Average Tenure, 1995

Italy Japan France Sweden Germany Spain United Kingdom United States Korea

Total

Men

Women

11.6 11.3 10.7 10.5 9.7 8.9 7.8 7.4 5.2

12.1 12.9 11.0 10.7 10.6 9.8 8.9 7.9 5.9

10.6 7.9 10.3 10.4 8.5 7.2 6.7 6.8 3.4

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Source: OECD Employment Outlook (1997).

case law has strengthened employee protection by introducing strict conditions under which employers may dismiss workers other than for malfeasance. Specifically, before an employer can dismiss workers it needs to be able to show that it has excess labor, that it has tried every other alternative, that it has an objective way of choosing its target, and that it has reached an agreement with the union. The OECD (1999a) finds that Japan ranks among the stricter OECD countries in terms of employment protection legislation. Yashiro (1999) finds that in the majority of cases in which large firms have tried to dismiss workers, case law has found their dismissals to be invalid. A number of changes have taken place in the labor market in recent years. Some evolution away from the “lifetime employment” and seniority-based wage systems has occurred, although views differ on how widespread this is, and the government has not actively targeted the issue.3 The government has, however, introduced a number of measures to improve the functioning of the labor market. For example, the professions that can be handled by private job placement and temporary employment service (“job dispatching”) agencies were expanded in late 1999 to give the private sector a greater role in the job search and temporary employment markets. More recently, the job dispatching period for older workers was extended to up to 3 years (compared with up to 1 year for younger workers). The social safety net was also enhanced in April 2001 by extending the maximum term of unemployment benefit payments from 300 days to 330 days for middle- and old-aged workers who were involuntarily separated from their previous jobs, while 3Genda and Rebick (2000) argue that change has been gradual and that the traditional employment system will endure, while Kato (2002) endorses the notion that an increasing number of firms are introducing a performance-based wage system to replace parts of the seniority-based system.

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upgraded training support was provided for unemployment benefit recipients in the September 2001 “Comprehensive Employment Measures” package. However, significant impediments to a flexible labor market remain. There has been little progress in easing existing employment protection legislation, and government policies to address the increasing skills mismatch have not yet been successful. Important sectors such as construction and medical services are on the lists that preclude private job placement and dispatching agencies from operating in these areas. Publicly supported retraining programs to help the unemployed obtain the skills needed to reenter the workforce have often been ineffective owing to their lack of customization and specialization, and international experience suggests that greater private sector involvement is needed to make programs more effective (OECD, 2000b). The government has taken steps toward improving these programs in the priority reform package in the fall of 2001 and in the first FY2001 supplementary budget, although clear results are yet to be seen. Further, while the new defined contribution pension schemes could ease the process of switching jobs for employees, it is not clear to what extent these pensions will develop under the existing tax system. Finally, despite the recent increase in the duration of unemployment benefits, this may still not be enough to provide an adequate safety net for the unemployed.

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Barriers to Entrepreneurship The formation of new businesses plays a crucial role in the growth process, being a manifestation of new ideas and products and an important part of the resource reallocation process in response to a changing economic environment. However, the rate of new business start-ups in Japan is low by international standards, and has declined over time compared with the broadly stable rate of start-ups in the United States (Table 5.5).4 While the low level of new business formation was not a constraint on the high growth rates that were achieved until the late 1980s, when growth relied heavily on intra-firm expansion, there are a number of reasons why the decline may be a concern now (Imai and 4The rate of business failure is also lower in Japan than in the United States, although it has picked up in recent years, reflecting the change in the economic environment and the introduction of the Civil Rehabilitation Law in April 2000, which provided a court led debtor-in-possession corporate reorganization process similar to the U.S. Chapter 11 procedure. However, while in the United States the rate of new business formation has always exceeded the rate of business failures, in Japan the opposite was the case in the 1990s.

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4.6 5.6 5.8 5.8 6.3 7.2 8.0 8.6 9.0 9.8 10.0 10.8 11.1 11.4 11.6 11.7 11.7 13.2 ... ...

1.6 .. 1.4 3.4 .. .. .. .. .. 2.0 .. .. 1.8 8.4 .. .. 4.1 3.3 5.4 6.8 . .

. .

. . . . .

.

Source: Partial reproduction of Imai and Kawagoe (2000).

Japan Sweden Finland Italy Switzerland Belgium Norway Austria Greece Denmark Netherlands Portugal France United States Spain Ireland Germany United Kingdom Israel Canada

2–4 2–4 ... 22 ... ... ... ... ... ... 12 ... 4–8 1–2 19–28 ... 8–24 1 ... ...

2,100–6,000 1,130 ... 7,700 ... ... ... ... ... ... 900 ... 1,900–4,600 200–800+ 330+ ... 750–2,000 900 ... ...

Formalities for Establishing a Business __________________________________ Time needed Estimated costs (weeks) (ECU) 0.036 0.131 0.089 0.059 0.048 0.076 0.107 0.010 0.019 0.022 0.218 0.057 0.095 0.141 0.051 0.062 0.062 0.408 ... ...

Venture Capital Investment (percent of GDP) 32.5 39.0 9.6 27.1 35.8 10.2 .. .. 48.5 .. 7.2 54.4 4.2 15.3 35.0 .. 11.1 12.0 .. 5.4

.

.

.

. .

Underpricing at Initial Public Offering (percent)



Start-Up Rate (percent) _______________________________ CompanyPopulationbased based

Table 5.5. Indicators Related to Entrepreneurship

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Kawagoe, 2000). First, the end of the growth process relying on technological catch-up has required companies to be more innovative, and deregulation and globalization have opened up new opportunities and competitive challenges. In this environment, large established companies may lack the flexible organizational structures and entrepreneurial abilities to respond quickly to changing market circumstances. Second, evidence from Japan suggests that, despite past reliance on existing companies to drive the growth process, younger and smaller companies still tended to grow faster, implying in turn that a key source of growth momentum could be deteriorating with the decline in the rate of start-ups. A number of factors are generally believed to affect the incentives for new business start-ups, including the availability of risk capital, the legal infrastructure, the administrative processes that need to be followed, flexibility of the labor market, and demographic factors (young people are likely to be more entrepreneurial). In Japan, cultural factors that attach a social stigma to those who fail in their attempt to start a new business could also be added. The availability of finance, including venture capital finance—a form of private equity that targets start-up firms primarily in emerging industries—is essential for new business formation and the development of new technologies. Venture capital firms also provide guidance and other forms of support to operations that are needed by small startup companies. However, given the domination of bank-intermediated finance and the relatively underdeveloped nature of the securities markets, the availability of equity capital to early stage start-ups has generally been lacking in Japan. Venture capital is supplied primarily through the financing arms of banks and other financial corporations, and has tended to focus on the later stages of firm development or the financing of leveraged buyouts of existing firms rather than funding the creation of new ones. Imai and Kawagoe (2000) estimate that 38 percent of new venture capital investment went to companies that were over 20 years old in FY1996, a further 20 percent to those between 10 and 19 years old, and less than 25 percent to those less than 5 years old. Venture capital has also been deterred by tight listing requirements that make it difficult to take young companies public and may explain the emphasis on investment in later stage companies. The administrative burdens placed on a prospective entrepreneur are also an important factor. Nicoletti, Scarpetta, and Boylaud (2000) ranked Japan thirteenth out of 21 countries in terms of the administrative burdens for start-ups, based on the number of procedures, the number of services, delays in the procedures, and direct and indirect costs. Imai and Kawagoe (2000) suggest that it takes twice as long and costs

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about 10 times as much to start a business in Japan compared with in the United States. The government has taken a number of measures to stimulate business start-ups. The Basic Law on Small and Medium-sized Enterprises was revised in 1999 to shift policy away from protecting these enterprises and toward providing support for new business creation. The New Business Creation Promotion Law, originally introduced in late 1998, was expanded in 1999 to provide partial exemption from the provisions of the Commercial Code and greater financial support to create a more conducive environment for starting new businesses.5 The Industrial Revitalization Law of 1999 also offered tax incentives to promote start-ups, while the so-called “Angel Tax,” expanded in 2000, introduced preferred treatment on both realized gains and losses from investment in nascent firms to attract investors. A series of new capital markets have been established to facilitate the transaction of shares of new firms, including the New Market, the Market of High-growth and Emerging Stocks, and Nasdaq Japan; the future of the latter is in doubt, however, after the decision by Nasdaq to withdraw from the joint venture. The financial “big bang,” by easing entry into the securities business, has also reduced the cost of initial public offerings (IPOs). As a result of these measures, the average time between establishment and IPO has been reduced significantly in recent years—to a little under 15 years in early 2002 from over 30 years in the mid-1990s—but remains long. However, the still limited availability of venture capital, substantial administrative burdens, and rigidities elsewhere in the economy remain disincentives to business formation. Regulatory Structure and Competition Policy Enforcement Controls on entry act as important impediments to market competition in a number of key sectors of the economy. For example, in the retail sector, the Large-Scale Retail Law (in effect until mid-2000) tightly regulated the entry of stores larger than 1,000 square meters, a relatively low threshold by international standards. In June 2000, the Large-Scale 5The exemptions include the relaxation of restrictions on the distribution of stock options (the ceiling was raised from 10 percent of outstanding shares to 33!/3 percent) and the potential recipients expanded to include outsiders such as consultants and programmers in addition to company executives and employees; and greater flexibility for issuing nonvoting equity (the ceiling for such issues was raised from one-third of outstanding shares to one-half) and the grace period during which the absence of a dividend payment does not result in the conversion of the shares to common stock was extended from one year to three years.

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Retail Law was replaced by the Large-Scale Retail Location Law. Under this law, new stores over 1,000 square meters must obtain the approval of prefecture governments subject to their meeting social screening criteria and, in practice, this legislation still appears to impede the entry of large retail stores into the market. The statutory period within which an application to establish such a store must be processed—at eight months—is also long. As a consequence of the restrictions placed on the entry and operations of establishments in the retail sector, Boylaud (2000) ranked Japan as having one of the most restricted retail distribution sectors among OECD countries. Restrictions on large stores have been designed to protect small shops from competition, with the aim of safeguarding the employment and amenities they provide. As a consequence, the retail sector in Japan is dominated by small establishments (“mom-and-pop” stores), which account for 55 percent of retail employment, while the market share of the national retailers has remained almost unchanged since the mid-1980s compared with the significant increase that has been seen in the United States (McKinsey Global Institute, 2000). The restrictions placed on large-scale stores have a number of negative consequences: they limit the services that new retail formats can offer consumers; they slow down consolidation and modernization in the retail sector; and they reduce firms’ market power over suppliers and consequently have implications for efficiency further up the supply chain (Boylaud, 2000). As large retail firms, or firms with cooperative arrangements, are generally found to be more innovative than small independent firms (OECD, 1997), this market structure leads to a lack of investment in technology and advertising and weak merchandising, which in turn hampers productivity. Indeed, McKinsey Global Institute (2000) estimates that productivity in the retail sector in Japan is only about one-half that in the United States. Another area in which controls on entry inhibit market competition is telecommunications, which has become one of the most important infrastructures for business operations in the modern economy, particularly given the increasing role of the IT sector. Telecommunications liberalization in Japan began quite early (in 1985), but the degree of competition that has been introduced varies significantly across different segments of the industry (Box 5.1). While the cost of long-distance and international calls and mobile phone services have declined rapidly since the liberalization in the respective sectors, competition in the local telephone remains limited. Despite the split of Nippon Telegraph and Telephone (NTT) into regional firms (and a long-distance service provider) under a holding company in 1999, its size and large network have continued to sustain its dominance in the domestic local call

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Box 5.1. Developments in Japan’s Telecommunications Industry Japan was among the first countries to take steps toward deregulating its telecommunications industry. After over 30 years of segmented monopoly in domestic and international calls, competition in the Japanese telecommunications market was first introduced in 1985, with the entry of new common carriers in long-distance and international services, followed by the privatization of Nippon Telegraph and Telephone (NTT) in 1985. By comparison, in the United States, the liberalization of interstate services took place in 1980, separation of regional operators from AT&T into regional monopolies in 1985, and liberalization of local markets in 1996 (see the table). Liberalization in Japan’s mobile phone market took place in 1988. Boylaud and Nicoletti (2000) classify Japan under the most liberal group of countries in terms of the telecommunication regulation, along with Canada, the United Kingdom, the United States, Sweden, and Australia. Deregulation has led to significant competition in some markets, and has resulted in a reduction in telephone service charges. Competition has been most notable in the mobile phone sector as a result of the deregulation, with the new carriers accounting for 41 percent of mobile phone contracts by early 2002. The market share of the new common carriers has also expanded substantially in the international and long distance sectors to about 47 percent. Telephone charges in these markets have declined substantially during Regulation of Entry, 1998

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Legal Conditions of Entry ____________________________________ Trunk International Mobile (digital)

Australia Germany Japan United Kingdom United States

Year of Liberalization ___________________________ Trunk International Mobile (digital)

Open Open Open

Open Open Open

Limited by spectrum Limited by spectrum Limited by spectrum

19911 1998 1985

19911 1998 1987

1992 1991 1988

Open

Open

Limited by spectrum

1985

1986

19842

Open

Open

Limited by spectrum

1984

1984

1983

Source: Boylaud and Nicoletti (2000). 1Initially a duopoly. 2Duopoly 1984–91.

market, and the cost of local telephone services, which includes high connection fees and charges based on the duration of the call, is high by international standards. In turn, this affects the spread of new services, including Internet access. A number of factors have constrained competition in this important sector of the market, including the lack

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Telephone Charges in Japan (1995=100) 160 140

CSPI, cellular

120 CPI, excluding fresh food

100 80

CSPI, domestic, fixed

60 40

CSPI, international, fixed

1990

91

92

93

94

95

96

97

98

99

2000

01

02

Copyright © 2003. International Monetary Fund. All rights reserved.

Sources: Ministry of Public Management, Home Affairs, Posts and Telecommunications; Bank of Japan; and staff calculations.

the 1990s, with cellular phone charges falling by over 60 percent and tariffs for international calls by one half. Competition in local telephone services is, however, still very limited as deregulation has fallen far short of that in other markets. NTT has retained its virtual dominance in the local telephone market even after it was split into one long distance and two regional operators in 1999.1 While network connection charges have fallen by over one-third since 1995, the price of local phone calls (mostly charged on the duration of calls) have not fallen as fast as for cellular and other services—in Tokyo, the price remained some 50 percent higher than that in other major foreign cities in 2000 (Ministry of Public Management, Home Affairs, Post and Telecomunications, 2001)—and the setup costs to acquire a telephone number have stayed high (see the figure). Consequently, the number of mobile phone subscriptions exceeded that of fixed phone lines in late 2000. 1Although varying in extent, this feature of the local market lagging behind other markets in the development of competition is shared in other countries—in the United States, the local market was liberalized in 1996, but new entrants’ sales remained below 4 percent of the total in 1998.

of clear information to applicants on the minimum requirements to receive licenses, high interconnection charges, the lack of transferability of telephone numbers (which confers an advantage to the incumbent), and fragmented regulations on rights of way and facility sharing (OECD, 2000b).

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To promote greater competition, recent legislation has, for example, prohibited dominant operators from unreasonably discriminating against other operators and required them to create firewalls between companies within their corporate group. NTT companies have also been permitted to expand their operations into other sectors of the telecommunications market.6 A carrier preselection system was also introduced in May 2001. Although the network connection charges to NTT will be reduced by 22!/2 percent by 2003 (from the 2000 level), the resulting costs will remain high by international standards. In addition, further regulatory reform to keep pace with industry developments (such as interconnection with the cable television (CATV) network and innovations in the IT sector) will be needed. Vigorous enforcement of the competition policy framework is also required. The basic competition law in Japan—the Antimonopoly Act—prohibits unreasonable restraints of trade, monopolies, unfair practices, and anticompetitive mergers, and provides a generally sound legal basis for competition policy. Exemptions to the Act have, however, undermined its role, although these have been greatly reduced in recent years (for example, exemptions previously given to the electricity, gas, and railway industries were removed in June 2000). Although legal enforcement by the Fair Trade Commission—which is attached to the Ministry of Public Management, Home Affairs, Posts, and Telecommunications—is becoming more vigorous, it remains limited (OECD, 1999b). The Council on Economic and Fiscal Policy’s reform blueprint emphasized that a more effective competition policy is needed to advance the role of market forces in the economy, and highlighted the importance of strengthening the role of the Fair Trade Commission, including by expediting investigations and improving transparency. This stance is maintained in recent reform initiatives, including the basic policy package and regulatory reform agendas. To do this, the Fair Trade Commission needs to have adequate resources and the appropriate structure to give it the independence and neutrality to carry out its mandate. 6The maximum foreign ownership of NTT stocks was also increased from 20 percent to 33 percent. An advisory board to the former Ministry of Post and Telecommunications recommended in late 2000 that consideration be given to reducing the NTT holding company’s stake in the NTT group of companies (100 percent of NTT Communications, 64 percent of NTT DoCoMo, and 54 percent of NTT Data) if greater competition was not seen after two years following the enforcement of the law. While this provision was not included in the legislation, the minister in charge has requested that NTT reduce its ownership of these companies, improve its efficiency, and open up its networks to competitors that do not have their own lines.

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In some key sectors—including telecommunications, electricity, and gas—there is no clear separation of the government’s regulatory and policy functions. For example, the Ministry of Public Management, Home Affairs, Posts, and Telecommunications is the regulator and policymaker in the communications field, while the Ministry of Economy, Trade, and Industry plays a similar role in the gas and electricity sectors. This is in contrast to many other OECD countries where independent regulators have been established.

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Role of the Information Technology Sector The significant contribution that the IT sector has made to growth in a number of industrial countries in recent years has been well documented. The IT sector was also an important engine of growth in Japan during the second half of the 1990s, contributing significantly to exports, production, and investment. Japan is the second-largest IT producer in the world, accounting for about one-fourth of total production in 1997 (OECD, 2000a), with a particular concentration in consumer audio/video and office equipment, electronic components, and mobile phones. Investment in IT-related goods has increased significantly in recent years. Shinozaki (2000a, 2000b) estimates that the share of IT investment in business capital expenditure was 15 percent in 1997— broadly in line with estimates by Daveri (2000)—almost double the level in 1993. The Ministry of Economy, Trade, and Industry, using a broader definition of IT investment, estimates that the share of IT expenditure in business investment doubled between 1993 and 2000 to 28#/4 percent.7 The share of expenditure on IT-related goods and services in private consumption rose from 5–5!/2 percent before 1994 to 6!/2 percent in 1999 (Development Bank of Japan, 2000), while the penetration of personal computers and the number of people with access to the Internet increased sharply during 1998–2000, the latter partly due to increased access via mobile phone. Recent studies have found that the contribution of IT capital deepening to labor productivity growth has increased in recent years. The Economic Planning Agency (2000) finds that the contribution during 1996–99 was #/4 of a percentage point a year, compared with zero during the first half of the 1990s, while the Ministry of Economy, Trade, and Industry (2001) estimates the contribution at !/2 a percentage point during 1995–2000. Goldman Sachs (2000) estimates a larger impact of 7Calculations by the Research and Statistics Department of the Ministry of Economy, Trade, and Industry.

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1 percentage point during 1996–99, compared with !/2 a percentage point during 1990–95. They also find a significant spillover from IT capital to total-factor productivity, although the contribution has not increased in recent years. Further, Shinozaki (2000a) estimates that IT investment has raised potential growth in Japan by !/4 of a percentage point (although this is less than half of the estimated impact in the United States). Despite this growth in IT usage and its increasing importance to productivity growth, there are grounds for believing that the role of the IT sector could increase further in the future. On most measures, IT usage in Japan remains lower than in the United States, United Kingdom, and Australia, although above that in the euro area (Table 5.6). For example, despite the near-doubling of IT expenditure as a share of business investment in Japan between 1993 and 1997, it remained below the rates in the United States, United Kingdom, and Australia (Daveri, 2000). Further, the share of IT capital in the total private capital stock in Japan was only 8 percent in 1996, compared with 19 percent in the United States in 1994 (Shinozaki, 2000a). IT usage by consumers is also still comparatively low. Despite the strong rise in recent years, Internet penetration and access to personal computers considerably lags that in the United States and Australia, while Internet access for educational purposes remains low. The use of electronic commerce in Japan is also minimal, whereas in the United States it has become a significant alternative means of shopping. Further, despite the increased contribution of IT capital deepening to labor productivity growth in Japan in recent years, this contribution remains somewhat below that in the United States and Australia (although on par with the United Kingdom and Europe; see Table 5.7). A number of studies have reached similar conclusions on the factors that are preventing the further spread of IT. These include the following. • The limitations of the existing network, with the relatively high cost of IT usage and slow data transmission speeds. While Internet access costs in Japan are similar to those in the United States, high telecommunications charges push total access costs to 2–3 times the level in the United States (Figure 5.4). Meanwhile, Japan’s Internet is commonly built on ordinary voice lines, and the penetration of high-speed Internet connection services using cable television lines, DSL, or optical fiber cables, is minimal (Figure 5.5). • Acceptance of the benefits of IT may only be slowly developing. An international corporate survey conducted by the Ministry of

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31.5 (23.7) 37.1 (13.2) 49 68 80

Population with access to PCs5 Population with access to Internet6

Elementary schools with access to Internet7 Junior-high schools with access to Internet7 High schools with access to Internet7 4.9 1.37

95 95 95

58.5 (45.6) 55.8 (22.1)

98 64

30.0 19 (18) 19.0

Australia

United Kingdom

Germany

... ...

100 100 100

46.5 (41.1) 43.9 (16.0)

... ...

... ... ...

86 98

33.8 (27.0) 33.6 (13.6)

... ...

... ...

100 100 100

33.6 (27.9) 15.0 (12.8)

... ...

(Percent unless otherwise indicated) 0.4 4.2 3.9 17 26 11 ... ... ...

United States

50 91 98 ... ...

30.5 (18.9) 12.9 (5.9)

... ...

3.5 11 ...

France

Source: OECD; International Telecommunication Union; Lehman Brothers; and Japanese authorities. 1Percent of world production, as of 1997 (OECD, 2000a). 2Percent of total business investment, as of 1997 (Daveri, 2000). Figures in parentheses are estimates by Shinozaki (2000a) as of 1997. 3Percent of total private capital stock (Shinozaki, 2000a). 1996 for Japan and 1994 for the United States. 4As of 1998 (Shinozaki, 2000b). 5As of 2000 (ITU). Figures in parentheses indicate percentages in 1998. 6As of 2000 (Japanese authorities for Japan, United States, Australia, and United Kingdom, and ITU for Germany and France). Figures in parentheses indicate percentages in 1998. 7As of 1999 (Japanese authorities). 8Percent of total transactions, as of 2000.

Penetration of e-commerce: business to Penetration of e-commerce: business to consumer8

3.8 0.25

78 15

Executives with access to Internet4 Executives comfortable/familiar with Internet4

business8

24.5 16 (15) 8.6

Production1 IT-related investment2 IT investment stock 3

Japan

Table 5.6. Selected Indicators on IT Production and Penetration

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 101

2.0

1.9 0.7 0.1 ... ...

2.0

2.4 0.0 –0.4 ... ...

1.0 0.4 0.5 0.3 ...

1.6 0.6 0.5 0.9 0.5 0.4

1.5

1991–95

1.1 1.0 1.5 1.2 0.3

2.6

1996–99

1.2 0.6 1.0 1.0 ...

2.3 1.3 0.9 1.5 1.5 ...

2.8 0.9 0.2 1.8 1.8 ...

2.7 1.2 0.6 1.1 1.1 ...

2.3

1997–99

United Kingdom4 _________________________

1990–95 1996–2000 1991–96

Australia3 _________________________

Sources: Japanese authorities; Oliner and Sichel (2000); Goldman Sachs; and IMF. 1Economic Planning Agency (2000) for 1990–95 and 1996–99, and Ministry of Economy, Trade, and Industry (2001) for 1995–2000. 2Oliner and Sichel (2000). 3Cardarelli (2001). 4Kodres (2001). 5Goldman Sachs (2000).

Labor productivity growth (percent) Capital deepening (contribution) ICT contribution Other (contribution) TFP Labor quality

1996–99 1995–2000

United States2 _________________________

1.3 0.3 0.8 0.8 ...

2.1

1990–95

0.7 0.4 0.7 0.7 ...

1.4

1996–99

Euro Area5 _________________________



1990–95

Japan1 __________________________________________

Table 5.7. Contribution of IT Sector to Labor Productivity Growth

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Figure 5.4. Internet Utilization Charges1 (U.S. dollars) 100 Communications charges (20 hours/month2) Communications charges (40 hours/month2)

80

Access charges

60 40 20 0

an

Jap

3

sia any rm Ge

ne

o Ind

ea

r Ko

3 s n a a e ia d m AR pore hina ali nc iwa hin tate ays lan do ng S a str C g Fra Ta of C d S Mal u Fin n o i A e ing t S K i K e g d inc Un ite Hon ov Un Pr

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Source: Ministry of Economy, Trade and Industry (2001). 1Charges for connecting through dial-ups. 2Figures for countries charging by the number of calls (United States, Australia, and Finland) are calculated by assuming 30 calls in 20 hours a month and 50 calls in 40 hours a month. 3Flat-rate Internet services for Germany and the United Kingdom.

Economy, Trade, and Industry (2001) found that IT investment in Japan tends to be targeted at improving the efficiency of existing operations and transactions, rather than at more far-reaching changes in the corporate structure and operations. For example, while Japanese firms were found to invest more in software that helps product design than their counterparts in other industrial countries, their investments in the areas of resource planning, supply chain management, and customer relations were less. The Ministry of Economy, Trade, and Industry report also identified a lack of awareness of the potential benefits of IT among top management as a factor holding back greater usage. In Japan, more firms use private lines than the Internet for business-to-business e-commerce, suggesting that a significant proportion of transactions are taking place within corporate groups rather than with external clients. • Structural rigidities may also constrain companies from realizing the full benefits of IT. The lack of competitive pressures in some segments of the economy is likely to reduce the need for companies to innovate and become more efficient, while inflexible labor

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Figure 5.5. High-Speed Internet Connection Dissemination Rates1 (Percent) 70 Other 2

60

CATV

50

DSL

40 30 20 10 0

Korea

Hong Kong Singapore SAR

United States

Taiwan Province of China

Japan

China

France

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Source: Ministry of Economy, Trade and Industry (2001). 1The ratio of high-speed Internet users to total Internet users. 2Includes nascent high-speed media—i.e., wireless, satellite and fiber-optic cable systems—wherever data are available.

markets constrain the productivity benefits of introducing new technology. Meanwhile, impediments to new business start-ups may limit technological innovation. Social infrastructure, including education, the judicial system, and the government’s own operations may also be constraints. For example, the lack of IT education programs has resulted in a shortfall of IT professionals. Further, the small number of judicial professionals has limited the ability to deal with legal issues related to e-commerce, while the continued reliance of the government on paper-based operations discourage firms from changing their way of business administration. If such impediments were removed, IT investment could have a substantial impact on the medium-term performance of the economy. Shinozaki (2001b) estimates that IT investment in Japan stimulates production by a factor of 2.3, compared with 1.9 for total private nonresidential investment, while ¥1 trillion of IT investment creates— both directly and indirectly—an additional 80,000 new jobs. Assuming IT investment of ¥10 trillion over the next 10 years, broadly in line with that in the United States during 1992–2000, 800,000 new jobs would be created, sufficient to reduce the unemployment rate by 1 percentage point.

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Recognizing the critical role of the IT sector in the economy, the government formulated the “e-Japan Priority Policy Program” in March 2001. The goals of the program are to create an international best standard information and communications network, upgrade education and training in IT-related fields, promote e-commerce, establish an “e-government,” and secure safety and public confidence in the network. The program also identifies the policies to meet these goals, including greater competition in the telecommunications industry and the reform of e-commerce regulations.

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Conclusions The decline in productivity growth has been an important factor behind Japan’s poor economic performance during the 1990s. Further, productivity growth in Japan has lagged that in faster-growing industrial countries, while estimates suggest that productivity levels in the domestically oriented sectors of the economy are well below those in the United States. Consequently, there would appear to be substantial scope for structural reforms to raise productivity and boost growth potential over the medium term. The blueprint of the Council on Economic and Fiscal Policy in June 2001 and its successor package of basic policies announced in June 2002 contains a bold and broad-ranging reform agenda that will need to be implemented if the full potential of the economy is to be unlocked. However, there are a number of areas where the payoffs to reform could be particularly significant. • Labor market. A flexible labor market is an important component of a dynamic economy, to help reallocate resources from declining sectors to the new areas of the economy on which Japan’s future growth will increasingly depend. However, at present there are a number of impediments to the movement of labor, including the strict interpretation of existing employment legislation and the continued prevalence of the “lifetime employment” and senioritybased wage systems. Reforms in these areas, as well as other measures to improve the functioning of the labor market, will be important to increase labor mobility. • New business formation. Creating the climate and conditions whereby new firms are able to enter existing markets and establish new ones is an important aspect of a more competitive and efficient economy. However, the rate of new business formation in Japan has declined and is low by international standards, suggesting that this aspect of the growth process is lacking. Reforms have

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already been undertaken to encourage new start-ups, including the development of equity markets for new firms, but the limited availability of venture capital, substantial administrative burdens, and rigidities elsewhere in the economy remain important disincentives. • Regulatory environment. Impediments to competition remain in a number of key sectors. Regulations governing large-scale stores limit the scope for economies of scale and efficiency gains in the retail sector, while in the telecommunications sector the lack of competition in the local market means that call charges remain high by international standards. The enforcement of existing competition policy also needs to be strengthened to advance the role of market forces in the economy. The further development of the IT sector over the medium term will be important. While IT usage in Japan has expanded quite rapidly in recent years, there appears to be scope for further increases, although this will both depend on addressing some of the structural impediments highlighted above—including more flexible labor markets to encourage firms to introduce labor-saving technical innovations and greater competition in telecommunications to lower connection costs and improve data transmission speeds—and developing a greater acceptance of the benefits of IT among corporate management. The government’s recently updated “e-Japan Priority Policy Program” is an important step toward the further development of the IT sector.

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References Bayoumi, Tamim, and Charles Collyns, 2000, Post-Bubble Blues: How Japan Responded to Asset Price Collapse (Washington: International Monetary Fund). Boltho, Andrea, and Jenny Corbett, 2000, “The Assessment: Japan’s Stagnation— Can Policy Revive the Economy,” Oxford Review of Economic Policy, Vol. 16 (Summer), pp. 1–17. Boylaud, Olivier, 2000, “Regulatory Reform in Road Freight and Retail Distribution,” Economics Department Working Paper No. 255 (Paris: Organization for Economic Cooperation and Development). ———, and Giuseppe Nicoletti, 2000, “Regulation, Market Structure and Performance in Telecommunications,” Economics Department Working Paper No. 237 (Paris: Organization for Economic Cooperation and Development). Cardarelli, Roberto, 2001, “Is Australia a ‘New Economy’?” in Australia—Selected Issues and Statistical Appendix, IMF Country Report No. 01/55 (Washington: International Monetary Fund), pp. 5–26.

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Council of Economic Advisors, 2001, Economic Report of the President, January (Washington: U.S. Government Printing Office). Daveri, Francesco, 2000, “Is Growth an Information Technology Story in Europe Too?” IGIER Working Paper No. 168 (Milan: Innocenzo Gasparini Institute for Economic Research, Bocconi University). Development Bank of Japan, 2000, “Recent Trends in the Japanese Economy: Information Technology and the Economy,” Development Bank of Japan Research Report No. 9 (Tokyo: Development Bank of Japan). Dutz, Mark, and Aydin Hayri, 2000, “Does More Intense Competition Lead to Higher Growth?” World Bank Policy Research Working Paper No. 2320 (Washington: World Bank Development Research Group). Economic Planning Agency, 1994, Rakuichi Rakuza Kenkyuukai Chukan Houkoku (Interim Report of Committee for a Free Market, in Japanese) (Tokyo: Government of Japan). ———, 2000, Keizai Hakusho (Economic Survey of Japan, in Japanese and English) (Tokyo: Government of Japan). Edwards, Jane, and Jochen Schanz, 2001, “Faster, Higher, Stronger—An International Comparison of Structural Policies,” Lehman Brothers, Structural Economics Research Paper No. 3, March. Genda, Yuji, and Marcus E. Rebick, 2000, “Japanese Labour in the 1990s: Stability and Stagnation,” Oxford Review of Economic Policy, Vol. 16 (Summer), pp. 85–102. Goldman Sachs, 2000, “The IT Revolution—New Data on the Global Impact,” Global Economic Commentary, Goldman Sachs, Global Economics Weekly, October 18.

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Hayashi, Fumio, and Edward Prescott, 2002, “The 1990s in Japan: A Lost Decade,” Review of Economic Dynamics, Vol. 5 (Special Issue, January). Imai, Yutaka, and Masaaki Kawagoe, 2000, “Business Start-ups in Japan: Problems and Policies,” Oxford Review of Economic Policy, Vol. 16 (Summer), pp. 114–123. International Telecommunications Union, ITU Telecommunication Indicators (Geneva: ITU). Kato, Takao, 2001, “The End of ‘Lifetime Employment’ in Japan?: Evidence from National Surveys and Field Research,” Journal of Japanese and International Economies, Vol. 15 (December), pp. 489–514. ———, 2002, “Financial Participation and Pay for Performance,” in Paying for Performance: An International Comparison, ed. by John S. Heywood and Michelle Brown (New York: M.E. Sharpe). Kodres, Laura, 2001, “The New Economy in the United Kingdom,” in United Kingdom—Selected Issues, IMF Country Report No. 01/124 (Washington: International Monetary Fund), pp. 42–75.

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McKinsey Global Institute, 2000, “Why the Japanese Economy Is Not Growing: Micro Barriers to Productivity Growth,” July. Ministry of Economy, Trade, and Industry, 2001, Tsusho Hakusho (White Paper on International Trade), May (Tokyo). ———, 2000, Tsusho Hakusho (White Paper on International Trade), May (Tokyo). ———, and Sanwa Research Institute, 2000, “Keizai Kouzou Kaikaku no Kouka Shisan ni Tsuite (On Estimation of the Impact of Economic Structural Reform,” in Japanese), November (Tokyo). Ministry of Public Management, Home Affairs, Post and Telecommunication, 2001, “Denki Tsushin Sabisu ni kakaru Naigai Kakakusa Chousa no Gaiyou (Gist of the Survey on Price Differentials in Telecommunications,” in Japanese), September (Tokyo). Nicoletti, Giuseppe, Stefano Scarpetta, and Olivier Boylaud, 2000, “Summary Indicators of Product Market Regulation with an Extension to Employment Protection Legislation,” OECD Economics Department Working Paper No. 226 (Paris: Organization for Economic Cooperation and Development). Oliner, Stephen D., and Daniel E. Sichel, 2000 “The Resurgence of Growth in the Late 1990s: Is Information Technology the Story?” Journal of Economic Perspectives, Vol. 14 (Fall), pp. 3–22. Organization for Economic Cooperation and Development, 1997, OECD Report on Regulatory Reform, Vol. II: Thematic Studies (Paris: OECD). ———, 1999a, Employment Outlook, June (Paris: OECD). ———, 1999b, “The OECD Review of Regulatory Reform in Japan,” July (Paris: OECD).

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———, 2000a, OECD Information Technology Outlook 2000—ICTs, E-Commerce and the Information Economy (Paris: OECD). ———, 2000b, Economic Survey of Japan, December (Paris: OECD). Porter, Michael, 1998, “Measuring the Microeconomic Foundations of Economic Development,” in The Global Competitiveness Report 1998, by the World Economic Forum (Geneva: World Economic Forum). Scarpetta, Stefano, Andrea Bassanini, Dirk Pilat, and Paul Schreyer, 2000, “Economic Growth in the OECD Area: Recent Trends at the Aggregate and Sectoral Level,” OECD Economics Department Working Paper No. 248 (Paris: Organization for Economic Cooperation and Development). Shimpo, Seiji, and Fumihara Nishizaki, 1997, “Measuring the Effects of Regulatory Reform in Japan: A Review,” Economic Research Institute, Economic Planning Agency, Discussion Paper No. 74 (Tokyo: Economic Planning Agency). Shinozaki, Akihiko, 2000a, “An Empirical Analysis of Information-Related Investment in Japan and Its Impact on the Japanese Economy,” paper presented at session on The Information Technology Revolution, American Economic Association, 2000 Boston Annual Meeting, January. Also published as JDP

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Research Report No. 59–02 (Tokyo: Japan Development Bank), October 1998. ———, 2000b, “Japan’s Economy in the 1990s and Now—From the Viewpoint of Information Technology Investment,” July. ———, 2001a, “IT Kakumei ga Terashidasu Kouzou Mondai no Shinso” (The Depth of Structural Reform Highlighted by IT), Economics & Policy, No. 4, Toyo Keizai Shinpo-sha (Spring). ———, 2001b, “IT ga Semaru Nihon-gata Shisutemu no Kaikaku” (Reform of the Japanese System Urged by IT), Keizai Seminar, No. 554, Nihon Hyoron-sha (February).

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Yashiro, Naohiro, 1999, “Koyo Kaikaku no Jidai” (The Era of Employment Reform), Chuokoron-Shinsha (Tokyo: Chukoshinsho).

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III

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FISCAL POLICY CHALLENGES

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6 Population Aging: Its Fiscal and Macroeconomic Implications HAMID FARUQEE

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P

opulation aging will figure as a prominent feature of the Japanese economic landscape over the next century. According to demographic projections, Japan will have one of the highest ratios of elderly dependents among the major industrial countries by the end of this year, despite having the lowest share just a decade ago. This dramatic shift is expected to continue well into the new century and will likely have profound social and economic implications. At the policy level, the implications of an aging population have several dimensions in Japan. The social security system—consisting mainly of health care and pension benefits—will inevitably face rising costs associated with the increasing share of elderly dependents. In the absence of further policy reforms, the central government could be saddled with growing unfunded liabilities associated with these entitlement programs. In particular, the pension system, which is partially funded, will face a severe shortfall in meeting future pension obligations at prevailing contribution rates. This chapter develops a general equilibrium framework to examine the economic implications of population aging in Japan as well as the policies designed to address it.1 The macroeconomic effects of demographic changes in the model are manifested through two main channels: (1) on the supply side, changes in the age structure have 1A more thorough examination of alternative fiscal policies and social security reforms is provided in Chapter 7.

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implications for labor supply, and (2) on the demand side, population aging has implications for aggregate consumption, saving, and investment. Introducing these features into a multicountry framework based on MULTIMOD, the model is calibrated based on age-earnings and demographic data for Japan as well as for other industrial countries as a group. To introduce a policy dimension, the model is further extended to incorporate a social security transfer scheme. This allows policy parameters affecting net taxes—that is, taxes less transfers—to be directly incorporated into private sector behavior. The consumption and saving behavior in the model flows from a modern life-cycle paradigm (see Blanchard, 1985, and Faruqee and Laxton, 2000). Within this multi-cohort framework, younger agents tend to be net borrowers, reflecting the fact that permanent income exceeds current income; mature agents tend to be large net savers at the peak of their earnings potential; and finally, the elderly also tend to save (albeit to a lesser degree), reflecting precautionary saving in the face of lifetime uncertainty and retirement. Compared with many previous studies, the present analysis suggests somewhat smaller effects on saving rates from changing demographics. Much of the previous work is based on macroeconomic time-series evidence and reduced-form coefficients from saving regressions on dependency ratios. These older studies tend to find very large negative effects on saving rates from increasing dependency rates (see Meredith, 1995, for a summary of evidence for Japan). This paper takes a more structural approach, based on a model of overlapping agents whose behavior is more closely tied to the microeconomic evidence on household saving. In the case of Japan, as with many other countries, a stylized fact at the household level is that the elderly generally do not dissave (see Hayashi, 1986, and Weil, 1989). Consequently, population aging does not guarantee a large decline in aggregate saving, particularly when factors such as increasing longevity are also taken into account. The results can be summarized as follows. In Japan, demographics are defined by a sustained decline in birth rates and an increase in longevity, leading to an aging of the population. The sharp decline in fertility rates is also responsible for a significant decline of Japan’s population. As a result of a contracting workforce, the level of real GDP is projected to fall (from a baseline with a constant workforce) by about 20 percent cumulatively over the next half-century or so. In terms of growth, annual GDP growth in Japan may be lower by about 0.5 percent for some time as the economy settles to a long-run equilibrium with a permanently higher elderly dependency ratio and smaller supply of labor.

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In per capita terms, GDP per person declines slightly in the long run (relative to baseline). Output falls in proportion to the contraction of labor—measured in efficiency units. However, the percent decline in effective labor supply is larger than the fall in the (adult) population, as the share of elderly increases. Investment and saving levels also decline with GDP through the adjustment process. The decline in investment reflects the desire to shed capital in the wake of the contraction in labor and output, though investment rates (as a share of GDP) remain unchanged. However, saving rates and, hence, the current account ratio increase slightly as the population ages. Despite a higher proportion of elderly (who tend to save less), the increase in longevity and the decline in the inflow of young agents (who tend to have high consumption propensities) act to raise saving rates in Japan. In terms of policy implications, the analysis highlights the importance of taking into account prospective changes in the macroeconomic environment when evaluating policies that address the challenges posed by population aging. An assessment of fiscal sustainability, for example, that focused only on the social security dimensions would miss an important component of the analysis if it ignored the macroeconomic implications of demographic changes for the fiscal accounts. Similarly, the endogenous response in private behavior to various policy changes should also be taken into account when examining policy reforms. On this last point, the simulation analysis suggests that changes in social security benefits can have a notable impact on private sector saving. In particular, a balanced decline in benefit and contribution rates is shown to boost private saving rates by nearly half of the reduction in benefit rates, as agents anticipate having to self-finance more of their consumption in retirement.

Demographic Trends A central feature of Japan’s demographics is a long-run decline in fertility. In the postwar era, the total fertility rate—defined as the number of births per woman—experienced a sharp decline in a single 10-year span, falling from over 3!/2 births in 1950 to just 2 births in 1960. Since that time, the fertility rate has continued to decline generally, and now remains well below the replacement rate (see Figure 6.1).2 The implication for the overall population of this dramatic fall in fertility is that the

2See Takayama (1998) for a discussion of the factors underlying the decline in the fertility rate in Japan.

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Figure 6.1. Total Fertility Rate, 1950–2050 (Births per woman) 4

3

2 Projection

1

0

1950

60

70

80

90

2000

10

20

30

40

50

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Sources: Takayama (1998); and World Bank.

number of young adults or workers expected to arrive in the future (ignoring immigration) will decline significantly for some time to come. Redefining “births” as the inflow of new adults into the economy, Figure 6.2 shows the historical and projected evolution of Japan’s “birth rate” b since 1960. As evident in Figure 6.2, the inflow of young adults as a share of the adult population has declined significantly over the past 40 years; moreover, even assuming a modest recovery in fertility rate over the next 50 years, the “birth rate” is projected to remain far below its historical levels well into the next century.3 The long-run decline in Japan’s birth rate has two important demographic implications: a declining population and an aging population. As seen in Figure 6.2, the decline in the “birth rate” b is associated with a decline in the population growth rate n. In fact, given that fertility rates have already fallen to such an extent, a declining adult population (n < 0) can be expected for much of the twenty-first century. With smaller cohorts of new adults arriving in the future, the relative share of working-age people will diminish over time and the popula3To be consistent with the model, the focus here is on the adult population (that is, age 15+), and the birth rate is defined as the arrival rate of new adults or workers. Correspondingly, growth rates refer to the percent change of the adult population. In Figure 6.2, historical data and projections for the “birth” rate are constructed from data from the OECD and World Bank on the youngest adult cohort group—that is, 15–24 year olds—to yield the share of new adults arriving each period; this series resembles movements in the more conventional fertility rate shown in Figure 6.1 with a 20-year lag.

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Figure 6.2. Birth Rate and Population Growth, 1960–2150 (Percent of adult population) 0.04 0.03 0.02 Birth rate

0.01 0 Population growth

–0.01 1960

1980

2000

2020

2040

2060

2080

2100

2120

2140

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Sources: OECD and World Bank.

tion’s average age will increase. The result is a sharp increase in the share of elderly in the population. Figure 6.3 shows the dramatic rise in the ratio φ of Japan’s elderly dependents (age 65+) as a share of the adult population projected from the analytical model, as well as projections from Japan’s Ministry of Health and Welfare and the World Bank. It should be noted that while a decline in fertility is generally associated with an aging population, a contraction of the population need not occur, especially when mortality rates are also falling (that is, longevity is increasing). Among other industrial countries as a group, for example, while population aging and a slowdown in population growth is expected, the population is not expected to shrink to any large extent. However, the more precipitous decline in fertility rates in Japan implies that a declining population will also figure as a prominent feature of its demographics.

Age-Earnings Profiles in Japan A key component to the analysis of demographic effects is the nature of the age-earnings profile. Over the life cycle, individuals can expect a hump-shaped pattern to labor earnings. Initially, as agents join the workforce, they can expect a rising path of earnings, reflecting productivity gains that come from work experience and seniority wages that reward work service. Eventually, labor earnings level off and decline as agents move into retirement.

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Figure 6.3. Elderly Dependency Ratio, 1960–2150 (Percent of adult population) 0.4 MHLW

0.3

Model World Bank

0.2

0.1

0

1960

1980

2000

2020

2040

2060

2080

2100

2120

2140

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Sources: OECD and World Bank; Japan Ministry of Health, Labor, and Welfare (MHLW); and IMF staff estimates

The profile that summarizes the life-cycle earnings path is important in determining both supply-side and demand-side implications of population aging. On the supply side, age-earnings profiles provide an indicator of the changes in relative productivity and (inelastic) labor supply that occur over an individual’s working life. On the demand side, the anticipated path of labor income influences the saving plans of consumers over their lifetimes. Changes in the demographic structure of the population can thus have important macroeconomic implications for aggregate saving and labor, stemming from these life-cycle effects.4 To calibrate the model according to the life-cycle pattern of earnings, empirical age-earnings profiles for Japan are estimated using crosssectional data on wage-based salaries by age group for the period 1970 to 1997. The earnings data are adjusted by labor force participation rates, reflecting the fact that the share of persons with zero earnings (that is, those who are retired) varies across age groups. The age-earnings data thus represent the average earnings per person (not per worker) within each age category. The data points are shown in Figure 6.4, normalized relative to per capita labor earnings of the youngest cohort.5 4The

model is described in Faruqee (2002). are based on contract wages by age, adjusted for labor force participation rates, as reported in the Statistical Yearbook; the earnings data are combined for both male and female workers for the following age categories: 15–24, 25–29, 30–34, 35–39, 40–44, 45–49, 50–54, 55–59, 60–64, 65+. Midpoints of each age group were used in estimating the structural time-series equation relating earning to age. Ministry of Labor data on 5Data

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As shown by the data, relative earnings profiles have been stable over the sample period. This suggests that the underlying institutional and structural features that implicitly underpin the variation in relative labor earnings across age groups—such as seniority wages and retirement age—have also been fairly stable historically. In the analysis, the cross-sectional pattern between age and earnings that emerges from the data is taken as representative of the time-series pattern of an individual’s wage earnings over the course of his or her lifetime. Moreover, this relation between age and relative earnings is assumed to reflect the changes in relative productivity and labor supply that occurs over an agent’s life cycle.6 The profile essentially summarizes the nature and timing of the rise and fall in relative earnings that agents can expect as they become mature workers and then move (gradually) into retirement. To characterize an agent’s life-cycle income profile, nonlinear least squares estimation is used on the following equation: ry(s,t) = a1e–α1(t–s) + a2e–α2(t–s) + (1 – a1 – a2)e–α3(t–s),

(1)

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where ry denotes relative labor income, s and t represent cohort and time indices, respectively, and their difference determines the age of a particular cohort group. The restriction on the ai terms reflects the normalization that the youngest cohort (that is, when s = t) has relative income equal to unity. The fitted values of the estimated equation (1) are shown by the line in Figure 6.4.7

earnings—which include contract wages and bonus wages—would slightly raise relative earnings for the middle-age groups (age 35–54), but otherwise yields a very similar profile. 6An issue is whether the empirical relation between age and relative earnings fully reflects differences in productivity and labor supply. The presence of seniority wages, for example, may be more a matter of prestige than productivity and may overstate the gains in productivity that accompany the rise in earnings of mature workers. On this score, however, it should be noted that the estimated earnings profile (solid line) in Figure 6.4 tends to place the peak of relative earnings at an earlier age, when the productivity peak is perhaps more likely to occur. 7Nonlinear least squares estimates yield the following results (corrected standard errors appear in parentheses): α1 = 0.073** (0.001); α2 = 0.096** (0.002) α3 = 0.085** (0.001) – R2 = 0.92, D.W. = 1.31, S.E.E. = 0.18; where *(**) indicates significance at the 5 (1) percent level. The ai coefficients were obtained through grid search (a1 = a2= 200).

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Figure 6.4. Japan: Age-Earnings Distribution, 1970–97 (Relative to youngest cohort) Relative income 3.0 2.5 2.0 1.5 1.0 0.5 0

20

25

30

35

40

45

50

55

60

65

70

75

Age

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Sources: Japan Statistical Yearbook; and IMF staff estimates.

The income-profile parameters in equation (1) enter the model in two distinct ways. On the supply side, the parameters directly affect the dynamics of aggregate labor supply—measured in efficiency units— since they reflect the relative productivity and labor supply of workers at different ages. On the demand side, since consumption is (partly) based on permanent income, these income-profile parameters also affect consumption-saving plans through their impact on human wealth—that is, the present value of future labor income streams. Consumption/saving propensities do vary by age as consumers choose to smooth lifetime consumption in the face of life-cycle income. Younger agents tend to dissave or borrow if possible—that is, if they are not liquidity constrained—to consume at levels commensurate with permanent income, which exceeds current income.8 Older agents tend

8See Jappelli (1990) for evidence suggesting that younger agents—who tend to be relatively asset and income poor—are the segment of the population most likely to face borrowing constraints. Liquidity constraints are included in the model to also reflect the fact that consumption tends to be somewhat hump-shaped over the life cycle; see Attanasio and others (1995). This assumption also allows consumption to display some “excess sensitivity” to disposable income, reflecting the fact that some agents are unable to borrow and must consume out of current income; see, for example, Flavin (1981).

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to save for retirement when labor earnings are relatively high. Meanwhile, the elderly tend to save at lower rates (falling to zero) in retirement as they largely consume out of asset (including annuity) income and transfers. On this last point, unlike traditional life-cycle models—e.g., Diamond (1965)—the elderly do not dissave or run down financial assets in this model due to lifetime uncertainty. Instead, with retirement, agents build up wealth to some target level as a precaution against the possibility of remaining alive without labor income.9 This behavioral feature allows the multi-cohort framework to avoid a common criticism of standard life-cycle models that posit large negative saving rates among retirees.10 In terms of empirical evidence, the model’s behavioral implications appear consistent with numerous studies at the household level that find scant evidence of dissaving among the elderly.

Pension System To complete the analytical framework, social security needs to be modeled. An advantage of the multi-cohort approach is that social security transfers can be included in a straightforward fashion. In particular, a pension system can be introduced into the framework as follows. Consider the simple case of a lump-sum transfer scheme:

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tr(s,t) =

–α(t);s>j(t)

{ +β(t);s≤j(t) ,

(2)

where tr(s,t) represents the transfers paid or received by individuals, depending on their age. Younger generations s>j(t) pay into the system,

9See Davies (1981) and Abel (1985). Kotlikoff and Summers (1981) argue that retirement saving in traditional life-cycle models appears insufficient to explain the amount of wealth accumulation and the fact that 80 percent of wealth is inherited in the United States. But as Abel (1985) shows, a life-cycle model with precautionary saving and accidental bequests can largely address these issues. Liquidity constraints can also be shown to further augment the amount of capital accumulation in the model. 10Hayashi (1986) argues that positive saving among the elderly in Japan favors models with bequest motives over the life-cycle approach. Yoshiro and others (1997) argue, however, that in the case of Japan the micro data tend to overstate the positive saving rates of the elderly by underrepresenting poorer agents who reside with younger family members.

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while older agents or pensioners s≤j(t) receive a benefit. For any transfer scheme, a full-financing condition can be written as follows: t

∫tr(s,t)N(s,t)ds = 0.

(3) –∞ This general condition must hold for the transfer scheme to be deemed fully funded (that is, no unfunded liabilities). Otherwise, there would exist a financing gap that would need to be covered through other revenues or government borrowing. The amount of the financing gap is determined by the following relation:

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gap(t) = β(t)φ(t) – [1 – φ(t)]α(t).

(4)

A positive gap would indicate a shortfall of financing relative to benefits. Full-financing—a zero gap—would require the well-known condition that the benefit-to-contribution must equal the support ratio, defined as the number of working-age persons relative to elderly dependents. The case of payroll tax financing is straightforwardly extended. In that case, individual contributions α(s,t) would be age-dependent, determined by social security taxes paid on individual labor income—τy(s,t). In what follows, a social security transfer scheme along these lines is introduced into MULTIMOD, so that net taxes—taxes less transfers—replace the previous treatment of government revenues; social security benefits and contributions (as ratios to GDP) are taken as exogenous policy parameters. In terms of behavior, these benefit and contribution rates mainly affect private behavior through their implications for permanent income (i.e., the present value of future income less net taxes).

MULTIMOD Simulations Incorporating demographic dynamics and social security into MULTIMOD, this section conducts various simulations to assess the economic impact of a rising dependency ratio and to examine certain policies intended to address the challenges of population aging.11 To quantify the economic impact of demographic changes in Japan, a reference scenario is constructed whereby the population is assumed to be stationary in an initial steady state.12 Then, treating Japan’s demo11See Laxton and others (1998) for a description of the Mark III vintage of MULTIMOD. 12The Appendix describes in detail the reference scenario as well as an alternative counterfactual scenario and its comparative implications for the results.

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Table 6.1. Simulated Effects of Population Aging in Japan (Percent deviation from baseline, unless noted otherwise) Variable

2001

2005

2010

2015

2025

2050

2075

2100

Real GDP Interest rates1 Contribution to GDP: Consumption2 Investment2 Net exports2

–0.7 –0.2

1.4 –0.2

1.6 –0.3

1.7 –0.5

–0.9 –11.2 –17.4 –18.4 –0.4 –0.2 0.0 0.0

–1.0 0.0 0.3

0.3 0.4 0.7

0.8 0.3 0.5

0.9 0.4 0.4

–0.9 0.1 0.0

–8.8 –13.9 –14.7 –1.4 –2.4 –2.6 –1.0 –1.1 –1.1

CPI inflation1 GDP per adult Real exchange rate

0.2 –1.0 –2.4

–0.1 0.0 –2.6

–0.0 0.0 –2.0

–0.1 0.2 –1.6

–0.1 0.0 0.8

–0.0 –1.4 7.7

0.0 –1.2 10.5

0.0 –1.5 11.2

Current account balance1 Private saving rate1

0.2 0.5

0.4 0.6

0.4 0.5

0.5 0.6

0.5 0.6

0.3 0.5

0.2 0.4

0.4 0.5

Dependency ratio1 Population growth1

0.0 0.3

0.0 0.2

0.1 0.0

0.7 –0.1

2.0 –0.4

5.1 –0.3

4.0 –0.2

2.5 0.0

1Percentage 2Deviation

point deviation from baseline; interest rates are long-term nominal rates. from baseline value in percent of baseline GDP.

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graphic projections as a shock and assuming unchanged policies, the economic effects of population decline and aging are simulated.13 Table 6.1 and Figure 6.5 summarize the economic effects of demographic changes in Japan.14 With a declining and aging population, the level of real GDP is projected to fall by about 20 percent cumulatively (from baseline) in the long run.15 The decline in GDP largely occurs between 2025 and 13The public debt path is taken as given and social security benefit and contribution ratios (to GDP) are fixed. This is done to isolate the impact of population aging on the macroeconomy through its direct implications for saving, investment, and labor supply. The additional implications through the fiscal accounts and social security are taken up in Chapter 7. 14Table 6.1 shows the impact of the shock on the Japan block of the model in isolation—namely, treating world variables as exogenous and without further feedback. Examining the effects of demographic changes on Japan’s variables in a multicountry setting (with feedback effects) would yield very similar results. Adding demographic dynamics simultaneously for the other industrial countries, however, will change some of the implications of the model, particularly for external variables. These differences, are noted later. 15Initially, output and investment rise, owing to the fact that effective labor supply is growing at the outset relative to the stationary population assumed in the baseline. Significant aging (relative to baseline) does not occur till after 2015. An increase in effective labor supply—somewhat akin to a positive shock to labor productivity—tends to reduce the interest rate and boost saving and investment. But eventually, the decline in effective labor with population aging and contraction (similar to a negative productivity shock) leads to a rise in interest rates as saving and investment levels decline with output.

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Figure 6.5. MULTIMOD Simulation Effects of Population Aging and Decline Real and Potential GDP

Interest Rates

(deviation from baseline; percentage change)

(deviation from baseline; percentage points)

Real GDP

5

Potential GDP

Short-term rate

0.8

0

Long-term rate

0.4

–5 0

–10 –0.4

–15 –20

2000

2050

2100

2150

2200

–0.8 2000

Consumption, Disposable Income and Wealth

NEER

10

15

5

10

2200

RCI

5

-5

0

–10

–5

–15

–10

–20

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2150

(deviation from baseline; percentage change)

Real consumption Real disposable income Real wealth

–25 2000

2100

Nominal Effective Exchange Rate and Real Competitive Index

(deviation from baseline; percentage change)

0

2050

2050

2100

2150

2200

–15 2000

2050

2100

2150

2200

Investment and Capital Stock

Debt and Foreign Liabilities

(deviation from baseline; percentage change)

(deviation from baseline; percentage points)

Real investment

Real capital stock

Debt/GNP

10

5

5

0

0

Net foreign liabilities/GNP

–5

–5

–10

–10

–15

–15 –20 2000

2050

2100

2150

2200

–20 2000

2050

2100

Source: IMF staff estimates

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2200

Population Aging: Its Fiscal and Macroeconomic Implications

 125

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2075, when the demographic changes are most pronounced. In growth terms, annual GDP growth is lower by about 0.5 percent a year over this time period, before the economy settles to a longer-run equilibrium with a permanently higher elderly dependency ratio. In per capita terms, GDP per adult declines slightly in the long run (relative to baseline) for the following reason. The percent decline in output is in line with the contraction of labor, measured in efficiency units. However, the percent decline in effective labor is greater than the percent fall in the number of workers, given the aging of the workforce and the differences in labor productivity and supply across age groups implicit in the age-earnings profile. Extending the simulation further out (closer to steady state) would show the decline in per capita GDP to be about 5 percent relative to baseline, as the output-labor ratio returns to its baseline level.16 Investment and saving levels (relative to baseline) also decline in the long run with GDP. The fall in investment reflects the desire to shed capital in the face of declining labor and output in the economy, but the rate of investment (as a share of GDP) is more or less unchanged. Saving rates increase slightly as the population ages. Despite a higher proportion of elderly, who tend to save less, the decline in the inflow of young agents (who tend to have high consumption propensities) and the increase in longevity act to raise saving rates.17 Consequently, the current account surplus increases, mainly reflecting the rise in private saving. Correspondingly, the real exchange rate would depreciate initially before appreciating in the long run with the accumulation of net foreign assets.18

16With the initial decline in interest rates, the economy experiences some capital deepening (rise in the capital-labor ratio) and, thus, a rise in GDP per effective unit of labor. But because aggregate productivity is exogenous and the interest rate is fixed (equal to the world rate) in the long run, the capital-labor ratio is predetermined in the long run by the production function. 17An increase in longevity—namely, a decline in the mortality rate in the model—increases agents’ planning horizons and lowers their effective discount rate. Longer horizons and more patience tend to raise saving rates. See the Appendix for further discussion. Other parameters affecting consumption (such as liquidity constraints) could also have some bearing on the saving implications of demographics. For example, fewer liquidity constraints—that is, more dissaving/borrowing by younger agents—would tend to magnify the increase in aggregate saving rates from population aging. 18In multicountry simulations, the results for Japan are broadly similar to those shown in Table 6.1. With the single-country simulation (that is, small open economy assumption), the world interest rate is fixed; hence, the domestic interest rate in the long run is also fixed (equal to the world rate) by interest rate parity. In the multicountry case, however, the world interest rate is endogenous and tends to decline permanently with the world demographic shock. The reason is that world population growth is positive

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Policy Simulation The framework used in this chapter can also be used to examine the impact of various policies. In Japan, the debate over social security reforms has largely centered around the extent of benefit cuts and the methods for achieving sustainable financing. On the latter, concerns have arisen that the prospective increases in the payroll tax burden to finance future pension benefits could act as a disincentive to work.19 To examine some of the implications of pension reform, a dynamic simulation of changes in social security is considered. In particular, the effects of a permanent reduction in social security premiums and benefits are simulated. Contribution and benefits are both permanently reduced by 2 percent of GDP; the adjustment path to this long-run reduction is kept the same for both the expenditure and revenue side of social security so that the direct effect on the overall fiscal balance is always zero. Table 6.2 and Figure 6.6 show the simulated effects of a balanced reduction in social security contribution and benefit rates in Japan. A cut in these rates initially reduces consumption and output. Consumption remains below baseline for some period as agents increase their saving rates in response to the cuts. The initial slowdown in consumption underpins a decline in interest rates and some boost to investment. The saving effect is larger, however, and the current account ratio rises. Over the longer run, higher output and consumption levels are attained with the buildup of capital and net foreign assets.20 The increase in saving rates can be explained as follows. The reform redistributes disposable income from pensioners who receive less transfer income to workers who face lower payroll taxes. This latter group generally has higher marginal saving propensities. In addition to this distributional aspect, saving across all age groups would generally rise as

(for some time) with the shock, and the increase in labor supply spurs saving and investment abroad and leads to a decline in the world interest rate relative to the baseline. For Japan, domestic rates still tend to rise during the adjustment phase with aging, but then converge to the lower long-run level of interest rates internationally, which mitigates somewhat the fall in output in Japan. 19See Chapter 7 for a fuller discussion of social security and the menu of alternative reform options. Note also that labor supply is assumed to be inelastic (though agevarying) here and hence unresponsive to policy changes. In Chapter 7, labor supply effects are also considered. 20Multicountry simulations of this shock yield very similar findings. Note that the simulation in Table 6.2 ignores possible labor supply gains surrounding a cut in payroll taxes. This case is taken up in Chapter 7.

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Table 6.2. Simulated Effects of Pension Reform (Percent deviation from baseline, unless noted otherwise) Variable

2001

2005

2010

2015

2025

2050

2075

2100

Real GDP Interest rates1 Contribution to GDP: Consumption2 Investment2 Net exports2 Social Security Benefits/GDP1 Contributions/GDP1

–0.8 –0.2

0.4 –0.3

0.2 –0.2

0.3 –0.1

0.4 –0.1

0.4 –0.1

0.5 –0.1

0.5 –0.0

–1.1 0.0 0.3

–0.6 0.3 0.7

–0.5 0.2 0.5

–0.2 0.2 0.3

0.3 0.1 –0.0

1.0 0.1 –0.7

1.5 0.1 –1.1

1.8 0.1 –1.4

–0.0 –0.0

–0.2 –0.2

–0.6 –0.6

–1.5 –1.5

–2.0 –2.0

–2.0 –2.0

–2.0 –2.0

–2.0 –2.0

Current account balance1 Private saving rate1

0.2 0.4

0.5 0.8

0.5 0.7

0.6 0.7

0.6 0.7

0.7 0.8

0.7 0.8

0.7 0.8

1Percentage 2Deviation

point deviation from baseline; interest rates are long-term nominal rates. from baseline value in percent of baseline GDP.

individuals, faced with less generous pension benefits now or in the future, need to save more for their own retirement and future consumption. Quantitatively, the simulations suggest that private saving increases by 0.8 percent of GDP, or nearly half the amount of the reduction in benefits (2 percent of GDP).

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Sensitivity Issues Throughout the analysis, it has been assumed that the age-earnings profile remains stable in the face of demographic changes. Whether the stable historical relationship between age and relative earnings will prevail in the future, however, is an open question. With healthier seniors living longer and pension benefits possibly declining, older workers may decide to postpone retirement. A higher retirement age and similar considerations would tend to “flatten” the age-earnings profile and, hence, mitigate that economic impact of population aging.21 Intuitively, since the income profile largely determines age-specific characteristics in the analysis, a flatter profile suggests smaller differences across age groups and, thus, smaller economic implications from a changing age distribution. 21With a rapidly aging workforce, firms may find it more difficult to reward workers with seniority wages, which could affect the relative earnings profile. But, in a sense, this is consistent with the notion that seniority wages may not necessarily reflect higher productivity of older workers. Hence, the empirical age-earnings profile may already understate the decline in relative productivity of workers at advanced stages of their earnings cycle and, thus, may understate the labor supply effects of an aging workforce.

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Figure 6.6. MULTIMOD Simulation Effects of Pension Reform Real and Potential GDP

Interest Rates

(deviation from baseline; percentage change)

(deviation from baseline; percentage points)

Real GDP

0.4

Potential GDP

0.2

0.2

0

0

–0.2

–0.2

–0.4

2000

2050

2100

2150

2200

–0.4

2000

Consumption, Disposable Income and Wealth Real consumption Real disposable income Real wealth

0

0

–1

–2

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2050

2100

2150

2200

–4

2000

Real investment

Real capital stock

20 0

0

–20

–1

–40

2000

2050

2100

2150

2200

2050

2100

RCI

2150

2200

(deviation from baseline; percentage points)

1

–2

2150

Debt and Foreign Liabilities

Investment and Capital Stock (deviation from baseline; percentage change)

2

NEER

4 2

2000

2100

(deviation from baseline; percentage change)

1

–2

2050

Long-term rate

Nominal Effective Exchange Rate and Real Competitive Index

(deviation from baseline; percentage change)

2

Short-term rate

0.4

2200

–60

2000

Debt/GNP

2050

Net foreign liabilities/GNP

2100

Source: IMF staff estimates.

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2200

Population Aging: Its Fiscal and Macroeconomic Implications

 129

A countervailing effect, however, is the possibility that the extent of population aging and contraction may be understated. The demographic projections—taken as exogenous—are largely based on World Bank projections; these projections impose a stationary population by construction by 2150. However, in the case of Japan, the downward momentum in birth rates and population growth rates would require a significant stabilization and recovery for a stationary population to obtain within this time frame (see Figure 6.1). Another issue is total-factor productivity growth, which is taken as exogenous. Some have argued that the transition to a smaller, older workforce in Japan will require adoption of labor-saving technologies and human capital-intensive production (Kosai, Saito, and Yashiro, 1998). These production technologies may stand to benefit more from dynamic efficiency gains associated with technological change and improvement. Thus, the possible structural shift in the economy may entail a rise in the overall rate of technological progress in the economy, allowing output and living standards to rise at higher rates than otherwise.

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Conclusions Demographic changes will be a defining feature in Japan for the foreseeable future. A sustained decline in fertility rates underlies a rapid aging and decline of Japan’s population that can be expected to continue well into the new century. This dramatic demographic shift will likely have profound social and economic implications. Using a multicohort modeling approach and the information in empirical ageearnings profiles, this analysis has sought to quantify some of the macroeconomic implications of demographic changes in Japan. The results of the dynamic simulations can be summarized as follows. • Population aging and decline in Japan will likely result in slower growth in output for some time. Absent any significant acceleration in total-factor productivity, annual output growth in Japan would be lower by about 0.5 percent over the next half century or so as the workforce contracts. In per capita terms, GDP per person could also decline (relative to the case of no demographic changes) since the significant contraction of the population and workforce suggests an even larger decline in the effective labor supply, given the rising share of elderly. • Saving rates and the current account ratio need not decline significantly with an aging population. Though a higher share of elderly would tend to reduce saving rates, other aspects of

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demographic changes in Japan, such as fewer young adults (and youth dependents) and increased longevity, would tend to counterbalance the negative effects of population aging on saving rates. • In terms of policy implications, the analysis highlights the importance of taking into account prospective changes in the macroeconomic environment when evaluating policies that address the challenges posed by population aging. Moreover, the potential impact of social security reforms on private sector behavior should also be incorporated. On this last point, the simulations show that reforms to social security benefits could have large effects on private saving. In particular, the model suggests that a balanced decline in benefit and contribution rates would boost private saving rates by nearly half of the reduction in benefit rates, as agents anticipate having to finance more of their own consumption in retirement.

Appendix

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Reference Scenarios To calibrate the magnitude of demographic changes and their effects, one can construct for comparison purposes counterfactual scenarios wherein certain demographic variables remain unchanged. Using this reference scenario as an artificial baseline, one could then simulate the economic impact of Japan’s demographic projections, as determined by the behavioral features of the model and given unchanged policies.22 These simulation results are helpful in projecting—in model-consistent fashion—the future paths of key macroeconomic variables (e.g., interest and growth rates) under population aging when considering issues such as pension reforms (see Chapter 7). The counterfactual exercise is described here in the Appendix and is done in two different ways. In the first simulation, a stationary population is used as the reference scenario to help identify the effects of both population contraction and aging; in the second simulation, the effects of population aging alone are isolated. Japan’s demographic dynamics contain components of both phenomena. 22The basic simulations are conducted in a model without pensions to isolate the economic effects of population aging. A pension transfer scheme is later introduced when examining policy shocks.

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Population Contraction and Aging To examine the effects of a declining and aging population and workforce implied by Japan’s demographic projections, a counterfactual scenario is constructed where the birth and death rates are chosen so that the rise in the dependency ratio is curtailed somewhat and the population does not contract. Specifically, in the initial steady state, it is assumed the population is stationary with the birth rate constant at its 2000 level onward; the death rate is also set equal to this value (i.e., b – p = n = 0). Figure 6.A1 shows the evolution for the Japan’s birth rate and population growth rate under the counterfactual baseline scenario as well as under the alternative scenario of population aging. Figure 6.A2 shows the evolution of the elderly dependency ratio under both scenarios. Note that since the fertility rate has already declined (as part of history), some aging will also occur under the baseline scenario since the full effects on the dependency rate come only with a lag—that is, the present dependency ratio is still below its long-run level even if the population is stationary from this point forward. Comparing the two scenarios, one sees that the demographic shock underlying the aging scenario involves a continued decline in the birth rate. Population growth is initially positive and higher under the aging scenario before declining and turning negative below the zero growth rate maintained throughout the baseline scenario. This suggests that the mortality rate is also lower initially (that is, greater longevity) Figure 6.A1. Japan: Birth Rate and Population Growth Rate, 1960–2150 Copyright © 2003. International Monetary Fund. All rights reserved.

(Percent of adult population) 0.03 Birth rate: counterfactual scenario

0.02

Birth rate: aging scenario

0.01 Population growth rate: counterfactual scenario

0 Population growth rate: aging scenario

–0.01 1990

2010

2030

2050

2070

2090

2110

2130

Source: IMF staff estimates.

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Figure 6.A2. Elderly Dependency Ratio, 1990–2150 (Percent of adult population) 0.4 Aging scenario

0.3

Counterfactual scenario

0.2

0.1

0 1990

2010

2030

2050

2070

2090

2110

2130

2150

Source: IMF staff estimates.

under the population aging scenario than in the case of a stationary population. The fact that population growth eventually goes to zero in the aging scenario at a lower long-run birth rate further requires that the long-run death rate also remain lower than in the baseline.

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Population Aging To better isolate the impact of a changing age distribution, a second counterfactual or baseline scenario can be constructed where the population growth rate is identical to the aging scenario, but where the rise in the dependency ratio is muted. This is done by assuming a higher birth rate in the second reference scenario than in the aging case; correspondingly, the death rate is sufficiently raised so that the same population growth rate obtains. The paths for the b and n in these two scenarios are shown in Figures 6.A3 and 6.A4. Comparing these figures to those associated with the previous counterfactual scenario, one sees that the aggregative implications of a decline in the birth rate are removed in the second experiment, but the distributional implications are accentuated. In other words, the rise in the dependency ratio in the aging scenario is relatively much larger against the second counterfactual scenario than the first (Figure 6.A4 versus Figure 6.A2), but the growth differences are completely negated (Figure 6.A3).

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Figure 6.A3. Birth Rate and Population Growth Rate, 1990–2150 (Percent of adult population) 0.03 Birth rate: counterfactual scenario

0.02

Birth rate: aging scenario

0.01 Population growth rate: both scenarios

0

–0.01 1990

2010

2030

2050

2070

2090

2110

2130

2150

Source: IMF staff estimates.

The comparative effects of both counterfactual scenarios versus the aging scenario is summarized in Table 6.A1. The top half of the table shows the effects attributable to both population aging and decline relative to baseline; the bottom half of the table shows the effects due solely to aging. The results indicate that almost half of the long-run fall

Figure 6.A4. Elderly Dependency Ratio, 1990–2150 Copyright © 2003. International Monetary Fund. All rights reserved.

(Percent of adult population) 0.4 Aging scenario

0.3 Counterfactual scenario

0.2

0.1

0

1990

2010

2030

2050

2070

2090

2110

2130

Source: IMF staff estimates.

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Table 6.A1. Comparative Effects of Demographic Changes in Japan (Percentage point deviation from baseline unless noted otherwise) Variable

2005

2010

2015

2025

2050

2075

2100

1.4

1.6

1.7

–0.9

–11.2

–17.4

–18.4

0.3 0.4 0.7 0.0 0.2

0.8 0.3 0.5 0.1 0.0

0.9 0.4 0.4 0.7 –0.1

–0.9 0.1 0.0 2.0 –0.4

–8.8 –1.4 –1.0 5.1 –0.3

–13.9 –2.4 –1.1 4.0 –0.2

–14.7 –2.6 –1.1 2.5 0.0

Population Aging and Contraction Real GDP Contribution to GDP: Consumption1 Investment1 Net exports1 Dependency ratio2 Population growth2

Population Aging Real GDP Contribution to GDP: Consumption1 Investment1 Net exports1 Dependency ratio2 Population growth2 1Deviation

2.7

1.4

1.5

–0.6

–6.0

–7.9

–8.1

–4.2 1.2 5.6 0.0 0.0

–4.2 0.6 5.0 0.1 0.0

–3.7 0.8 4.4 0.5 0.0

–3.7 0.5 2.6 1.5 0.0

–4.2 –0.3 –1.6 5.6 0.0

–3.3 –0.6 –4.0 7.3 0.0

–2.0 –0.6 –5.5 7.6 0.0

from baseline level in percent of baseline GDP. point deviation from baseline.

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2Percentage

in GDP is due to an aging workforce and not just a shrinking workforce. In terms of saving behavior, because mortality falls (longevity rises) to a greater extent (see Figure 6.A3) in the second simulation—the second reference scenario versus the aging scenario—private saving will rise more in this case. As the death rate p falls, the planning horizon lengthens and the effective discount rate declines. Longer horizons and more patience on the part of agents tend to raise saving propensities. In the simulations, this can be seen by the larger initial fall in consumption and improvement in net exports in the bottom half of the table. In the long run, though, consumption falls by less because national income (and output) are higher as net foreign assets are accumulated.

References Abel, Andrew B., 1985, “Precautionary Saving and Accidental Bequests,” American Economic Review, Vol. 75 (September), pp. 777–91. Attanasio, Orazio, James Banks, Costas Meghir, and Gugliemo Weber, 1995, “Humps and Bumps in Lifetime Consumption,” NBER Working Paper No. 5350 (Washington: National Bureau for Economic Research). Also published in Journal of Business and Economics, Vol. 17 (January), pp. 22–35.

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Blanchard, Olivier, 1985, “Debt, Deficits and Finite Horizons,” Journal of Political Economy, Vol. 93 (April), pp. 223–47. Davies, James B., 1981, “Uncertain Lifetimes, Consumption and Dissaving in Retirement,” Journal of Political Economy, Vol. 89 (June), pp. 561–77. Diamond, Peter A., 1965, “National Debt in Neoclassical Growth Model,” American Economic Review, Vol. 55 (December), pp. 1126–50. Faruqee, Hamid, 2002, “Population Aging and Its Macroeconomic Implications: A Framework for Analysis,” IMF Working Paper 02/16 (Washington: International Monetary Fund). ——, and Douglas Laxton, 2000, “Life-Cycles, Dynasties, Saving: Implications for Closed and Small, Open Economies,” IMF Working Paper 00/126 (Washington: International Monetary Fund). Flavin, Marjorie A., 1981, “The Adjustment of Consumption to Changing Expectations of Future Income,” Journal of Political Economy, Vol. 89 (October), pp. 974–1009. Hayashi, Fumio, 1986, “Why Is Japan’s Saving Rate So Apparently High?” NBER Macroeconomics Annual: 1, pp. 147–210. Jappelli, Tullio, 1990, “Who Is Credit Constrained in the U.S. Economy?” Quarterly Journal of Economics, Vol. 105 (February), pp. 219–34. Kosai, Yutaka, Jun Saito, and Naohiro Yashiro, 1998, “Declining Population and Sustained Economic Growth: Can They Coexist?” American Economic Review, Papers and Proceedings, Vol. 88 (May), pp. 412–16. Kotlikoff, Laurence J., and Lawrence Summers, 1981, “The Role of Intergenerational Transfers in Aggregate Capital Accumulation,” Journal of Political Economy, Vol. 89 (August), pp. 706–732.

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Laxton, Douglas, and others, 1998, MULTIMOD Mark III: The Core Dynamic and Steady-State Models, IMF Occasional Paper No. 164 (Washington: International Monetary Fund). Meredith, Guy, 1995, “Demographic Changes and Household Saving in Japan,” and “Alternative Long-Run Scenarios,” in Saving Behavior and the Asset Price ‘Bubble’ in Japan, ed. by Ulrich Baumgartner and Guy Meredith, IMF Occasional Paper No. 124 (Washington: International Monetary Fund). Takayama, Noriyuki, 1998, The Morning After in Japan: Its Declining Population, Too Generous Pensions, and Weakened Economy (Tokyo: Maruzen). Weil, Philippe, 1989, “Overlapping Families of Infinitely-Lived Agents,” Journal of Public Economics, Vol. 38 (March), pp. 183–98. World Bank, 1994, Averting the Old Age Crisis: Policies to Protect the Old and Promote Growth (Oxford: Oxford University Press). Yashiro, Naohiro, Takashi Oshio, and Mantaro Matsuya, 1997, “Macroeconomic and Fiscal Impacts of Japan’s Aging Population with Specific Reference to Pension Reforms,” Economic Research Institute, Economic Planning Agency Discussion Paper No. 78 (Tokyo: Economic Planning Agency).

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7 Fiscal Policies During the Demographic Transition MARTIN MÜHLEISEN

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P

opulation aging is a common phenomenon in the industrialized world. Birth rates have been declining as prosperity has increased and, with the baby boom generation about to enter retirement, public pension schemes have come under pressure to raise contribution levels or cut the size of benefits. Japan will be particularly affected by this process. Its population is enjoying the highest longevity worldwide, and the share of elderly people relative to the working population is already among the highest in the world. By contrast, fertility rates are among the lowest in the world, implying that the age distribution of the population will shift rapidly in the coming decades.1 By 2025, there will be one elderly person for roughly two persons of working age, which will leave Japan with a significantly higher old-age dependency ratio than any other country in the industrialized world (see Table 7.1). As this demographic shock unfolds, Japan is facing substantially greater fiscal challenges than other countries. While most industrialized nations have been successful in reducing government deficits during the past decade, Japan’s fiscal situation has deteriorated dramatically following the government’s efforts to resuscitate the economy. The immediate task will be to return the government deficit to a sustainable level, which will be complicated by rising social security benefit payments and by the need to avoid an abrupt shift in the fiscal stance that could jeopardize the recovery. Even after the overall fiscal situation has 1See

Takayama (1998) for an overview of demographic trends in Japan.

136

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Table 7.1. Old-Age Dependency Ratios1

2000 2025

Canada

France

Germany

Italy

United Kingdom

United States

Japan

20 36

28 41

25 36

28 43

27 36

21 33

27 47

Source: United Nations, World Population Prospects 1950–2050, 1996 revision. 1Number of elderly (65 years and older) as percent of working age population (20–64 years of age).

stabilized, however, the government still faces the long-term task of preserving the solvency of the social security system. This chapter deals with fiscal policy measures that could be taken to restore fiscal sustainability and help achieve a smooth demographic transition. Based on the general equilibrium approach of MULTIMOD, the IMF’s global economic model used in Chapter 6, a detailed simulation of the Japanese fiscal accounts is used to address two key issues: • first, the degree of fiscal adjustment needed to stabilize public debt over the medium term, and the output costs of alternative fiscal strategies to achieve that target; and • second, the long-term implications of demographic developments on public finances under the present policy framework, and responses that would safeguard the viability of the social security system while mitigating the impact on economic growth.

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The Literature There is a broad consensus in the literature that population aging in industrialized countries will reduce output growth and limit increases in economic welfare (see Kohl and O’Brien, 1998, and OECD, 1998a, for a survey). A shrinking population will be associated with lower levels of employment and, thus, output, although the impact on per capita incomes could be mitigated by rising capital-labor ratios, productivity increases, and higher labor participation rates. However, to the extent that saving behavior is governed by life-cycle motives—that is, individuals save for retirement during their working life and dissave during retirement—most models predict that saving rates would decline as the share of the elderly population increases (e.g., Meredith, 1995). The ability of the government to stem this decline through higher public saving will be limited, owing to the increasing demand for higher spending on social services for the elderly. The conclusion reached by most papers is that, to maintain fiscal sustainability and preserve intergenerational equity, net public pension

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benefits would need to be substantially cut (Chand and Jaeger, 1996; OECD, 1998a, 1998b). Yashiro, Oshio, and Matsuya (1997) also point out the need for substantial labor market reforms in order to achieve higher participation rates among married women and reduce seniority wages that tend to act as a disincentive to hiring middle-aged and elderly workers. However, in focusing largely on the broad macroeconomic picture, this strand of the literature has generally provided scant help in choosing between different reform options. In general equilibrium models, the fiscal sector is usually treated on a fairly aggregated basis, and demographic effects have largely been captured through a simple dependency ratio (e.g., Masson and Tryon, 1990; Yashiro and Oishi, 1997). As a result, these models tend to lack the level of detail needed to analyze the pros and cons of structural pension reform measures.2 By contrast, a more pragmatic strand of the literature has focused on the implications of demographics for fiscal and pension policies, while largely neglecting the feedback between tax and spending policies and macroeconomic variables. A number of papers have projected government accounts on the basis of fixed assumptions for future output growth and interest rates. This has proved useful in illustrating the dimension of fiscal adjustments needed, but the results have suffered from the drawback that different policy measures may affect saving and investment incentives, labor supply decisions, and relative prices in quite different ways. For example, the question of whether to finance social security transfers through direct or indirect taxes could hardly be answered in such a framework. With that caveat, the results of a number of studies are summarized below. Although not necessarily comparable, they shed light on Japan’s fiscal challenge from different angles. • The Ministry of Health and Welfare regularly updates actuarial calculations to estimate the degree to which pension contributions would need to be raised to maintain solvency of the main components of the public pension scheme (see Takayama, 1998). The latest results—taking account of the recent pension reform— indicate that contribution rates to the main public pension system will still need to increase by about 50 percent to maintain financial viability (see below). • Chand and Jaeger (1996) estimated the size of pension liabilities for major industrial countries through 2050, based on World Bank 2Exceptions are macroeconomic models used by Aaron, Bosworth, and Burtless (1989) for the United States, and Yashiro, Oshio, and Matsuya (1997) for Japan—based on the 1994 pension reform—which have embedded in them explicit models for the finances of the social security system.

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demographic projections (World Bank, 1994), albeit with a somewhat simplified social security model. As of 1995, the present value of Japan’s net pension liabilities (through 2050) was estimated at about 110 percent of GDP, roughly on par with Germany and France. This result is within the range of Leibfritz and others (1995) and Roseveare and others (1996), who estimated the value of net pension liabilities for Japan at between 50 and 200 percent of GDP, depending on different productivity and interest rate assumptions. • A number of papers have followed in the tradition of Auerbach and Kotlikoff (1987) by applying generational accounting models to analyze the distributional consequences of fiscal policies. Takayama, Kitamura, and Yoshida (1998) and Takayama and Kitamura (1999) have identified large generational imbalances in Japan, with future generations expected to pay about 3–4 times more net taxes and social security contributions than the generation currently in retirement. Similar conclusions have been drawn by Hviding and Mérette (1998).

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Analytical Approach In this chapter, both strands of the existing literature are effectively combined. Policy assumptions affecting general government and social security finances are first fed into a small fiscal model that—under given macroeconomic assumptions—provides a long-term projection of fiscal accounts. The results of the fiscal model are then fed into MULTIMOD, which produces revised macroeconomic assumptions, and the process is repeated until a reasonable degree of convergence is achieved. This approach is used to generate a baseline model, which illustrates the likely fiscal and macroeconomic consequences of current government policies. Once a baseline scenario has been established, MULTIMOD is used to analyze the effects of alternative fiscal policies relative to those assumed in the baseline simulation (Figure 7.1). For the purpose of this chapter, the standard MULTIMOD framework was modified in two key points (see Chapter 6 on Population Aging by Hamid Faruqee for a fuller explanation).3 First, the saving and 3MULTIMOD is a macroeconomic general-equilibrium model that can be used to simulate economic developments in a global setting, including issues related to exchange rates, fiscal and monetary policies, and demographic developments. Given a set of policy assumptions, the model is constructed to search first for a long-term steadystate solution, and then produce a dynamic adjustment process that leads into the steady state. To arrive at a time-consistent solution, the model includes forward-looking agents,

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Figure 7.1. Old-Age Dependency Ratios Fiscal policy assumptions

Fiscal model

Macroeconomic framework

Path of fiscal variables

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MULTIMOD

consumption equations of the Japan model were disaggregated for different age cohorts, using age-earnings profiles from official survey data. This prepared the ground for a more realistic simulation of the saving behavior of an aging population, compared with earlier studies that worked largely through the age-dependency ratio. Second, with retirement income a key factor in life-cycle models, behavioral equations for private agents have been updated to include social security parameters, which permits modeling the effects of social security policies on the real economy. For computational purposes, the MULTIMOD framework also needed to be reduced to four major country blocks—Japan, the United States, other industrial countries, and emerging and developing countries—which nevertheless allowed for the simulation of capital flows generated by a shift in the distribution of saving and investment as a result of global aging. There are, however, two kinds of limitations to the approach of this paper. • From a conceptual point of view, the analysis focuses largely on the public finance sustainability angle of the aging problem, and does not explicitly search for an optimal intertemporal solution that distributes the financial burden in an equitable way across generations. Moreover, the role of private pension arrangements whose consumption and investment decisions depend on the steady-state outcome. See Laxton and others (1998) for a description and, for example, Faruqee, Laxton, and Symansky (1997) for an application of the model.

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(for example, corporate pension schemes and 401(k)-type pension plans) is not explicitly covered by this chapter. • On a technical note, the link between MULTIMOD and the fiscal model is not seamless. MULTIMOD was developed primarily for analyzing the effects of macroeconomic shocks in a forwardlooking/rational expectations framework, and does not lend itself easily to simulating actual levels of economic variables. Moreover, it is already a rather complex framework and adding a fully specified fiscal sector would have made the simulation unwieldy. Therefore, some macroeconomic parameters in the fiscal model were simulated independently, although projections for key variables, such as growth and saving, were obtained directly from MULTIMOD.

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Social Security and Government Finances Japan’s social security system is a multitier system covering public pensions, health insurance, and unemployment insurance.4 First-tier schemes (the National Pension and National Health schemes) provide pension and health coverage on an equal basis for all citizens. The second tier consists of occupational schemes—separate for private employees and public servants—that provide earnings-related pensions and expand somewhat on basic health benefits. It is also possible to take out higher insurance through supplementary (third-tier) schemes that are privately financed and managed (but benefit from a number of tax exemptions) and are typically offered by larger employers. The National Pension scheme provides a flat-rate “basic” pension for all residents of age 65 and older, independent of past labor force status.5 Additional earnings-related pensions are provided from age 60 by the Employees’ Pension Insurance for the bulk of private-sector employees, and by Mutual Aid Associations for public-sector workers. Benefits drawn under these schemes depend primarily on past monthly wages and the duration over which contributions were paid. Benefit increases are presently linked to the disposable income of active workers, with adjustments in the pension formula taking place every five years. During interim years, pensioners only receive cost-of-living adjustments. Contrary to most other industrial countries, pension benefits are virtu4A small public welfare system is considered part of the general government sector, and thus not included in the social security accounts. 5The full monthly pension was about ¥70,000 (US$600) in 2000. A reduced pension can be drawn starting from age 60.

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ally untaxed. The maximum replacement ratio for workers covered by earnings-related schemes is about 80 percent of net wages (Takayama, 1998), which is high by international standards, although the average net replacement ratio for the elderly population as a whole is only about 53 percent (Yashiro, Oshio, and Matsuya, 1997). Compared with some of the larger European welfare states, pension expenditure in Japan is indeed still fairly low, reflecting limited coverage of the earningsrelated pension scheme and the comparatively low level of basic pension benefits. Pensions are financed from three sources, the largest of which are pension contributions. Persons not covered by any occupational schemes (the jobless, self-employed, farmers, students, and their spouses) are required to pay a flat-rate contribution of ¥13,300 a month to the National Pension scheme. Participants in earnings-related schemes pay a fixed share of monthly basic wages in contributions, which is matched by employer contributions.6 To finance basic pension benefits for members of occupational pension systems, the National Pension Insurance receives financial transfers from the Employees’ Pension Insurance and Mutual Aid Associations in proportion to the number of beneficiaries that are covered by these schemes. The other two financial sources consist of government transfers, which are currently set at one-third of basic pension payments, and returns on public pension assets. Owing to large surpluses in the past, assets held by pension schemes have accumulated to about 50 percent of GDP—about six years’ worth of pension benefit payments, which is unparalleled among industrial countries (for comparison, public pension assets of the United States account for about 10 percent of GDP). These assets are largely invested through the Fiscal Investment and Loan Program, which provides loans to central and local governments, government financial institutions and public agencies (largely for the purpose of infrastructure investment), and holds large amounts of government securities. Owing to the nature of such investments, returns on pension assets have been comparatively low, dropping to below 2 percent since FY1999 from about 6–7 percent in the 1980s. The authorities have taken steps to improve the solvency of the social security system. The 2000 pension reform bill contained provisions to cut lifetime pension benefits by about 20 percent for future retirees, particularly through a reduction in benefit levels by 5 percent for future retirees, a gradual increase in the age of eligibility for earnings-related 6The Employees’ Pension Insurance contribution rate is currently 17.35 percent of monthly basic wages, shared equally by employer and employee.

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pension payments to 65 beginning in 2013, and fully indexing Employees’ Pension Insurance pension increases to the consumer price index instead of disposable income. At the same time, government transfers to the basic pension scheme are to be raised from one-third to one-half of basic pension benefits from 2004. Nevertheless, according to Ministry of Health and Welfare calculations, the Employees’ Pension Insurance contribution rate would still have to rise to 25 percent of monthly basic wages by 2025 (from the current level of 17!/4 percent) to maintain solvency.7 Even with such an increase, Employees’ Pension Insurance reserves would shrink to about 3!/2 years worth of benefit payments. Health insurance coverage in Japan is universal, based on an organizational structure that is similar to the pension system. The National Health Insurance scheme provides basic benefits for all residents, and there are numerous occupational schemes (including the Employees’ Health Insurance, health insurance schemes run by the Mutual Aid Associations for public employees, and company-managed schemes mainly for employees of larger companies). Elderly persons (from the age of 70) are covered separately by an old-age insurance system. Unlike the pension insurance, first- and second-tier health benefits are very similar. Japan has adopted a fee-for-service system, with most of the medical services provided by private hospitals and clinics. Access to providers does not depend on the type of insurance coverage, and differences with respect to required co-payments were eliminated by the June 2000 health care reform bill (both members of occupational schemes and National Health Insurance members are now reimbursed for 70 percent of medical expenses). Medical care for the elderly is almost fully covered, requiring only very small co-payments.8 Costs for medical services are regulated by a medical fee schedule (which is revised every two years), and drug prices are also standardized, with drug expenses being reimbursed in line with other medical expenses. Compared with other major industrial countries, health expenditure in Japan has been fairly low relative to GDP. Although the system exerts only limited control on demand, and private suppliers have incentives to provide excessive quantities of service, health spending is on a level comparable to countries with nationalized health services, such as the United Kingdom. While underlying health factors that have con7Under the pension reform, the wage base for pension contributions is to be broadened to include bonus payments (which account for an average of 20 percent of total worker compensation), but the contribution rate will be reduced to keep the change revenue-neutral. 8Under the reform bill, co-payments for the elderly were also increased to up to 20 percent, depending on income levels, as of April 2003.

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tributed to Japanese longevity probably also imply less need for medical services, strict price controls and increases in co-payments in recent years have also been effective in keeping overall expenditure low (Oxley and others, 1995). This is likely to change, however, as the Japanese population grows older. With persons over 65 consuming roughly four to five times as much in health services as younger persons, a strong rise in health expenditures can be anticipated (Table 7.2). Financing of health benefits is provided to a substantial extent by public transfers, which differ across various schemes. On average, subsidies cover about one-half of total benefits for the National Health Insurance, one-third of old-age medical care spending, and 12 percent of expenditure by occupational schemes—which translates into an average of 30 percent for public health expenditure as a whole. Since elderly people are exempt from health insurance contributions and pay only small co-payments, other insurance schemes together provide 70 percent of financing for old-age medical benefits through financial cross-transfers. The situation of Japan’s public finances has worsened dramatically during the 1990s. Tax revenues receded strongly after the collapse of the asset price bubble in the early 1990s, and expenditures have been driven upward by economic stimulus measures, above all public works spending, and by the costs of assuming the liabilities of a number of failed financial institutions (Mühleisen, 2000a). As a result, the general government deficit reached an estimated 8!/2 percent of GDP in both 1999 and 2000 (excluding the social security surplus), and even if Japan’s cyclical position is taken account of, the structural deficit remains worse than that of other G-7 countries (Table 7.3). Although Japan’s net general government debt appears broadly in line with other countries (at about 60 percent of GDP in 2000), this figure includes assets owned by the social security system—accounting for 50 percent of GDP—which are more than offset by future pension claims. If social security assets are excluded, Japan’s debt situation is Table 7.2. Public Health Expenditure, 1995 (Percent of GDP) Canada Total health expenditure Public expenditure

France Germany

Italy

United United Kingdom States

Japan

9.6

9.8

10.4

7.7

6.9

14.2

7.2

6.9

7.7

8.2

5.4

5.9

6.6

5.7

Source: OECD Health Data, 1997.

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Table 7.3. General Government Finances, 2000 (Percent of GDP) Canada Actual balance Structural balance Gross debt Net debt Net debt, excluding social security

3.2 3.1 102.6 66.3 ...

France Germany –1.4 –1.1 57.5 48.0 ...

1.2 –1.1 60.3 51.6 ...

Italy –0.3 –0.7 110.2 104.4 ...

United United Kingdom States 4.0 1.6 41.3 35.1 ...

1.9 1.5 57.3 43.6 ...

Japan –8.41 –8.11 135.7 57.5 97.7

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Source: IMF, World Economic Outlook, October 2001; and IMF staff estimates. 1Excluding social security.

considerably worse than that of other industrialized countries. General government debt (excluding social security) has roughly doubled over the past decade, and markets have been concerned that the true level of public debt could be even higher, given the possibility that the government might have to cover contingent liabilities from loan guarantees and losses by public sector enterprises. The current fiscal situation clearly appears unsustainable and calls for strong adjustment measures in coming years. However, the problem for the authorities lies in reducing the fiscal deficit in a way that will not jeopardize the nascent economic recovery. In 1997, the last attempt at fiscal consolidation had to be abandoned as a rise in the consumption tax rate and a cut in public works spending were among the factors contributing to the renewed economic downturn. Although factors other than fiscal policy were at work on that occasion, the principle that fiscal consolidation needs to take account of evolving economic and financial conditions—including the robustness of the recovery— remains a valid one.

Long-Term Baseline Simulation for Government Finances This section describes the outcome of a baseline simulation that takes stock of Japan’s long-term fiscal problem.9 The simulation is modeled as closely as possible on the authorities’ current policy intentions, for example, by incorporating reforms in the recent pension legislation, but the simulation does not assume major additional reforms in as yet 9All simulations are based on data that were available in early 2000. Since then, revisions to both fiscal accounts and GDP statistics have resulted in a somewhat lower deficit ratio and a higher public debt ratio. The outcome of the simulations has, however, not been affected in a material way.

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unspecified areas. The need for further measures is mainly captured through changes in a residual fiscal variable necessary to maintain fiscal stability. In what follows, this variable is assumed to be the consumption tax rate—which is still relatively low by international standards and carries less economic disincentives than, for example, the income tax rate.10

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Demographic and Macroeconomic Background The following simulations use demographic projections prepared by a World Bank team (World Bank, 1994) that also have been widely used in earlier studies. The projections imply that Japan’s population will reach its maximum of 128 million people in 2010. The old-age dependency ratio would plateau at about 45 percent between 2020 and 2030, before rising again to peak at 55 percent by 2050.11 More recent population projections, including by the Japanese authorities and the United Nations, have assumed an even faster decline in fertility rates, which leaves the Bank’s projections at the optimistic end of the current forecast spectrum. The projections have been retained, however, in part because they are based on the assumption that the population will converge toward a steady state, which is a necessary condition for undertaking the MULTIMOD simulations. However, to avoid painting too optimistic a picture in the simulations, the age distribution has been slightly shifted toward the elderly (by assuming extended longevity), thus approximating the Ministry of Health, Labor, and Welfare’s oldage dependency ratio while maintaining population levels projected by the World Bank team (Figure 7.2). The overall macroeconomic outcome of the simulation is described in Chapter 6. The results—which also incorporate the fiscal baseline assumptions explained below—show that, although Japan’s long-term saving rate would remain broadly unchanged compared to a stable demographic scenario, the output loss resulting from a shrinking labor force could still reach 15–20 percent in the steady state. The finding of a broadly unchanged saving rate is related to rising longevity, which causes individuals to save more in their productive phase, and a reduction in younger workers, which reduces the share of the population that 10Under unchanged fiscal policy settings—a frequently used reference scenario— Japan’s debt levels would obviously explode. However, the notion that policies would remain unchanged under such circumstances would not be realistic, making that scenario an unsuitable baseline for policy analysis. 11The simulations extend through 2070—that is, beyond the peak of the age dependency ratio.

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Percent of employee compensation

Japan's Lost Decade : Policies for Economic Revival, International Monetary Fund, 2003. ProQuest Ebook Central,

90

2000

10

20

80

90

2000

10

20

40

30

Balance

40

Expenditure

Balance before transfers

Revenue

30

50

50

National pension

Mutual pensions

Health

Social Security Operations

80

Unemployment

Employees' pension insurance

Social Security Collection Rates1

60

60

70

70

Thousands of yen at 1995 prices

90

2000

10

80

90

Assets

2000

10

EPI Assets

Social Security Assets

1970

0

10

20

30

40

50

60

70

80

Pensions

20

20

40

50

30

40

50

EPI reserve ratio (right scale)

30

Medical costs (right scale)

Old age medical costs (right scale)

Real Social Security Benefits (Per Beneficiary)2

1970

0

500

1000

1500

2000

2500

3000

Sources: National Income Accounts; and IMF staff projections. 1Total revenue divided by aggregate wage payments. 2Benefits received by the elderly are divided by the number of persons aged 65 and above.

1970

–10

–5

0

5

10

15

Percent of GDP

20

25

30

1970

0

2

4

6

8

10

12

14

16

Percent of GDP

Figure 7.2. Social Security Operations, 1970–2070

60

60

0 70

1

2

3

4

5

6

7

8

0 70

200

400

600

800

1000

1200

1400

1600

Percent

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 147

Thousands of yen at 1995 prices

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MARTIN MÜHLEISEN

dissaves. Finally, owing to rising demand for funds for capital investment, real interest rates would gradually rise toward a long-term level of about 3 percent. While significant, the output loss projected by this simulation would only be a relative loss (compared to a scenario without a demographic shock), which would not necessarily imply absolute negative output growth in the future. Although the labor force would shrink significantly and higher labor force participation would be discouraged by rising wage deductions from taxes and social security contributions, this would be mitigated by an increase in the capital intensity of the production process (the baseline model predicts that the capital-labor ratio would roughly triple by 2050), and positive total factor productivity growth (the baseline scenario assumes total factor productivity growth of about #/4 percent a year). However, even under relatively strong investment growth, potential output growth would peak at about 2 percent over the next decade and then decline over time toward its steady-state rate of #/4 percent over the next 50 years. Owing to a shrinking population, per capita growth would average about 1 percent over that period.

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Baseline Projection: Social Security Finances The model for projecting the finances of social security is complicated by the large number of different schemes and the complex system of financial transfers (see Mühleisen, 2000b, for details), but the simulation is based on a few main assumptions. • Pension payments. These are modeled to increase largely in line with consumer prices and the number of retirees. Employees’ Pension Insurance pension cuts would be implemented as foreseen by the recent pension reform bill, and other earnings-related pension benefits would follow a similar pattern. • Pension contributions. As envisaged by the government, flat rate contributions to the National Pension scheme would increase by ¥800 in real terms every year between 2005 and 2020. Similarly, Employees’ Pension Insurance pension contribution rates would initially rise in five-year steps, reaching 27!/2 percent of monthly wages in 2025, although two further rounds of increases are assumed to bring the rate to 28!/2 percent by 2050, and 30 percent thereafter, to limit the drawdown of pension assets.12 Contribu12The difference with official calculations—which project a rise in the Employees’ Pension Insurance contribution rate to only 25 percent—appears mainly related to the higher growth path assumed by the Ministry of Health and Welfare.

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tion rates to other pension schemes would rise in line with the Employees’ Pension Insurance scheme. • Health spending. Rising longevity, more intensive treatment options, and a possibly growing demand-supply gap are estimated to push up real per-patient medical expenditure almost twofold over the next decades, absent a determined effort to contain health care costs. The introduction of nursing care insurance and an increase in copayments could somewhat dampen the upward trend in medical expenses per elderly person, but these are nevertheless expected to almost double over the forecasting period. Health care contributions are assumed to rise to the extent necessary to maintain financial balance of the health insurance system, as they have in the past. On the basis of these assumptions, the social security system is expected to remain solvent throughout the projection period. Overall pension expenditure would stabilize at about 12 percent of GDP by 2020 (up from 7!/4 percent in 1998), partly owing to a slower increase of real per-retiree benefits as a result of the planned increase in the Employees’ Pension Insurance retirement age. With the planned contribution rate increases, assets held by the pension schemes are projected to remain stable relative to GDP through 2020. Although reserve ratios (assets over annual benefit payments) would temporarily fall during this period, a further increase in contribution rates by 2025 would ensure sufficient asset accumulation to maintain solvency through the peak of the aging process in mid-century (Table 7.4, Figure 7.3).

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Table 7.4 Projected Social Security Operations, 1998–2050 (Percent of GDP) Actual 1998

Projection Projection Projection Projection Projection 2010 2020 2030 2040 2050

Premium revenue Pensions Health insurance Government transfers Property income

10.9 6.9 3.7 2.8 1.8

12.4 8.0 4.2 4.4 1.7

14.4 9.2 4.9 5.6 2.1

14.6 8.9 5.4 6.1 2.5

14.4 8.3 5.8 7.0 2.9

13.9 7.9 5.7 7.6 2.5

Benefit payments Pensions Health insurance Other expenditure

12.9 7.3 5.1 0.5

16.3 9.4 6.5 0.5

20.0 11.6 8.0 0.5

20.6 11.5 8.9 0.5

22.8 12.6 10.0 0.5

23.7 13.0 10.5 0.5

2.1

1.7

1.6

2.1

0.9

–0.2

50.0

49.6

51.2

59.8

64.9

57.8

Balance Memorandum: Social security assets

Source: National Accounts data; and IMF staff projections.

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90

2000

80

90

10

Net debt

2000

30

20

30

50

40

50

Gross debt

40

Net debt (excluding social security)

20

Balance

Primary balance

10

Revenue

Expenditure

General Government Debt

80

Real GDP

Sources: National Income Accounts; and IMF staff projections.

1970

200 180 160 140 120 100 80 60 40 20 0 –20

1970

–10

0

10

20

30

40

50

60

60

Figure 7.3. General Government Operations, 1970–2070

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Percent of GDP

Percent of GDP

70

70

Percent of GDP 1970

18 16 14 12 10 8 6 4 2 0 –2

1970

–10

–5

0

5

10

15

20

25

30

35

90

2000

10

20

30

40

50

Balance (excluding social security)

Expenditure

60

80

90

2000

10

20

30

Net interest expenditure

Capital expenditure

40

Current expenditure (excluding social security and interest)

Indirect taxes

50

60

Direct taxes

General Government Revenue and Expenditure Items

80

Balance (excluding social security and social security transfers)

Revenue

General Government (Excluding Social Security)

70

70



Percent of GDP

150 MARTIN MÜHLEISEN

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 151

Public health spending would rise from 5 percent in GDP in 1998 to 8 percent of GDP in 2020 and to more than 10 percent of GDP by 2050 (comparable to OECD 1997 projections). Health insurance contributions would have to increase to keep up with rising public expenditures. From the current level of about 8 percent of wages, contributions would be expected to rise to 11 percent over the next 25 years, before peaking at 13 percent by the end of the forecasting period. The impact of population aging on the fiscal accounts is apparent from the fairly drastic increase in government transfers implied by these projections. Under present formulas, transfer payments would rise from the current 2#/4 percent of GDP to 5!/2 percent of GDP in 2020 and more than 6 percent of GDP in 2050, by which time the bulk would be spent on health benefits. While these transfers would ensure that the overall balance of social security would remain positive for most of the projection period—preventing a drawdown of assets until the demographic peak around 2050—they would clearly impose a heavy burden on the overall fiscal situation.

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Baseline Projection: General Government Finances The simulations for general government finances are guided by a gradual approach to fiscal consolidation, represented by two operational policy targets:13 • Stabilize net debt within 10 years. The simulation assumes that the government would embark on a sustained path of fiscal consolidation to stabilize net debt (excluding social security assets) at about 120 percent of GDP by 2010. • Reduce debt levels gradually in subsequent years. The pace of overall fiscal consolidation is assumed to slow once the demographic transition gets fully under way after 2010. Nevertheless, further measures are assumed to be implemented to offset rising social security transfers and avoid substantial crowding-out of private investment over the long-term. It is assumed that general government debt (excluding social security assets) would be reduced to roughly 60 percent of GDP by 2070 compared with 120 percent in 2010 and almost 90 percent of GDP today. The first policy target implies that the general government deficit (excluding social security) would need to be reduced from 9!/2 percent 13To

facilitate the analysis, no distinction was made between central and local government operations, and activities of public agencies outside general government (for example, the Fiscal Investment and Loan Program) were not explicitly modeled.

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of GDP in FY2000—as estimated in early 2000—to 2!/2 percent of GDP within 10 years. To achieve this reduction of 7 percentage points, it is assumed that the government would pursue the following strategy (Figure 7.4). • It is likely that public works spending would be substantially cut following the onset of recovery, given the questionable return from such investment in the past. Public investment is assumed to fall by 3!/2 percent of GDP to reach the G-7 average of 4 percent of GDP by 2010. The withdrawal of stimulus would be somewhat mitigated by a Ricardian reaction of the private sector (which also appears to have limited the effectiveness of such policies in recent years). • While interest payments and social security transfers would rise by a combined 2!/2 percent of GDP, spending cuts as well as administrative reforms currently under way could affect other current expenditure (for example, payroll spending, employment subsidies), although the room for overall reductions is limited owing to rising costs for public servants’ pensions, which are borne directly by the government. Savings in that area are projected at 1 percent of GDP, which would leave other current expenditure higher relative to GDP than during most of the 1990s. • On the revenue side, direct tax collections could be boosted by a cyclical recovery in income tax revenues (although a pickup in corporate tax revenue would lag for several years, owing to loss carry-forwards) and by base-broadening measures. Although measures to expand the tax base could perhaps yield as much as 10 percent of GDP in revenue collections according to OECD estimates, the baseline only assumes additional revenue of 1–1!/2 percent as a result of such efforts, owing to potentially large political resistance. Overall, direct tax revenue is assumed to rise by about 3 percent of GDP through 2010, which would be comparable to revenue levels in the mid-1980s. Under these assumptions, the increase in indirect tax revenue required to achieve the debt target would be about 2 percent of GDP, which would be equivalent to a hike in the consumption tax rate from 5 percent to 10 percent by 2010. In view of the 1997 experience, this would be a rather significant adjustment, which would need to be phased in carefully over the full 10-year horizon. Achieving the assumed long-term policy target—a reduction in net general government debt (excluding social security) to about 60 percent of GDP by 2070—would require additional adjustment measures of 4 percent of GDP. This is assumed to be achieved largely through further

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Figure 7.4. Macroecomonic Effects of Fiscal Consolidation Strategies (Difference from baseline scenario; percent) Investment cuts

VAT increase

Direct tax base broadening

0.75 0.50

Real GDP

0.25 0 –0.25 –0.50 –0.75 –1.00 –1.25

2000

02

04

06

08

10

12

14

16

18

20

06

08

10

12

14

16

18

20

06

08

10

12

14

16

18

20

1.0 Real Private Consumption 0.5 0 –0.5 –1.0 –1.5

2000

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3

02

04

Real Private Wealth1

2

1

0

2000

02

04

Source: IMF staff calculations. 1Real financial assets plus discounted real income over the projection period.

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indirect tax increases. First, following the adjustment measures through 2010, there appears to be limited room for further expenditure cuts, especially as welfare obligations are likely to remain high. Second, income tax measures would be made more difficult by the continued rise in social security taxes. Indeed, income tax revenues are likely to decline somewhat relative to GDP, owing to a drop in the overall share of labor income, an increase in the share of older workers in the labor force, and increases in alternative work arrangements (such as part-time work). As a result, indirect tax revenue would need to steadily increase from 10 percent in 2010 to a peak of about 14 percent in 2050, consistent with a rise in the consumption tax rate to 24!/2 percent, which would be larger than today’s VAT levels in other major industrial countries. .

Sensitivity Analysis For obvious reasons, the results of the baseline scenario are at best indicative. Given the long forecasting period, the simulation outcome is highly sensitive to the underlying assumptions, and the focus should thus be more on broad trends in macroeconomic variables rather than a single scenario itself. To help in assessing such trends, the results of two different simulations are presented in Table 7.5, involving one scenario with more pessimistic demographic projections and a second one with stronger productivity growth. Table 7.5. Sensitivity Analysis: Social Security Indicators, 2050

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(Percent)

Baseline Real benefit levels per beneficiary (2000 = 100) Pension (average) General health insurance Old-age medical care Contribution rates Pensions (EPI) Health (average) Government transfers to social security (percent of GDP) Consumption tax rate Memorandum: Average per capita growth rate, 2000–50

Weaker Demographics

Higher Total Factor Productivity Growth

126.3 178.3 196.6

108.6 162.1 168.4

130.1 180.1 196.4

28.5 13.0

35.0 15.1

28.2 12.3

7.6

8.4

6.4

24.6

29.4

17.8

0.9

0.8

1.1

Source: IMF staff calculations.

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• Weaker demographics. The population projection by World Bank (1994) used in the baseline scenario projects a recovery in the fertility rate to 1.6 or more over the next 25 years, compared with its 1999 level of 1.34. However, the birth decline in recent decades appears to have been mostly related to an increase in the marriage age as more women enter careers, and there is little evidence so far to suggest that a reversal in this trend is about to occur (Yashiro, Oshio, and Matsuya, 1997). Therefore, this scenario assumes the fertility rate to stabilize at about 1.3 percent, which would result in a continuous population decline toward the steady-state level of 80 million, and an increase in the age dependency ratio to 80 percent by 2050 (20 percentage points higher than in the baseline model). • Technology change. A second scenario assumes total-factor productivity growth at 1 percent, or 20 basis points higher than the historic average used in the baseline scenario. As the Japanese economy is likely to become more capital intensive, particularly through investment in new technologies, and with a gradually advancing structural reform process, it would not be unrealistic to expect TFP growth to accelerate in the future (Table 7.5). The results show that the financial consequences of weaker demographics could indeed be severe, and they also highlight the importance of growth for preserving Japan’s social security system. Under more pessimistic population projections, both benefit cuts and further contribution increases would be necessary (relative to the baseline), especially in the pension system, which depends to a lesser degree on government transfers. Even if pension benefits were kept almost unchanged from their current levels in real terms, the Employees’ Pension Insurance contribution rate would need to be raised to 35 percent. Similarly, despite lower real health care benefits, medical contribution rates would be higher than in the baseline, and the consumption tax rate would also need to be increased to achieve the assumed long-term fiscal target. However, the high consumption tax rate of 29 percent indicates that absent a more severe effort to curb medical expenditure (which would imply lower government transfers), it would become almost impossible to finance public health insurance in its current form. By contrast, higher total-factor productivity growth would imply that the benefit levels of the baseline scenario could be maintained at reduced contribution levels as well as lower government transfers, implying that the consumption tax rate could also remain at significantly lower levels than in the baseline model.

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Policy Analysis The baseline simulations show that a policy of slow debt consolidation and gradual social security reforms would be a long-term drag on living standards, because of the economic disincentives posed by high social security contribution rates and indirect tax increases necessary to finance rising government transfers and interest payments. What could be gained by pursuing different policies, and at what cost? To respond to these questions, this section presents alternative policy paths—both for stabilizing government debt and for restoring the long-term viability of the social security system—and analyzes their impact on growth and welfare relative to the baseline scenario, using the MULTIMOD framework.

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Speed and Composition of Fiscal Consolidation One option for the government would be to achieve debt stabilization faster than the 10-year period assumed in the baseline scenario. While the benefits of such a policy are obvious in theory—including positive debt dynamics and higher public saving—there could be a drawback if strong fiscal adjustment measures stalled the recovery, making eventual fiscal consolidation all the more difficult to sustain. Moreover, multiplier analysis suggests that cuts in public investment could have particularly strong negative effects on growth, whereas tax measures would tend to affect output on a smaller scale. Thus, there is a question not only regarding the speed of fiscal adjustment, but also the composition of fiscal measures. To illustrate the macroeconomic trade-offs, three simulations have been run under the assumption that general government debt is stabilized over a period of five years. Compared with the baseline scenario, the stronger fiscal path is assumed to result from the following policy measures: (1) cuts in public investment; (2) an increase in the consumption tax rate; and (3) direct tax base broadening.14 Faster consolidation would stabilize debt at a lower level than in the baseline, and it is assumed that this positive debt differential is maintained through the end of the forecasting period. All other assumptions (regarding social security parameters, technology, etc.) remain unchanged from the baseline scenario. 14The case of higher direct tax rates was also considered, but it produced an inferior outcome compared with both consumption tax increases and base-broadening measures.

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As expected, faster consolidation would result in sustained gains to economic output over the medium term, although at the cost of shortterm losses. Real output would decline relative to the baseline scenario for the first three to four years of the adjustment process, but rise above baseline output for the rest of the forecasting period. The largest long-term gains would be achieved in the case of public investment cuts, but these would also entail the largest short-term output losses, with real GDP being 1!/4 percentage points below baseline output in the first year of the adjustment process.15 The cases of tax base broadening and consumption tax increases would imply a much smaller initial output loss as public investment would be kept unchanged, but long-term gains would also be smaller, owing to the distortionary effects of higher taxes (Figure 7.5). Long-term gains in real private consumption and private wealth (here used as proxy measures for economic welfare) also highlight the beneficial role of public investment cuts. Both measures increase immediately relative to the baseline scenario, whereas the other two strategies result in lower consumption for most of the time, as well as significantly smaller wealth gains.16 This reflects the fact that tax increases either directly reduce disposable labor income (in the case of direct taxes), or decrease future real incomes through an increase in consumer prices (in the case of consumption taxes). Three main policy conclusions can be drawn from these findings. • A shortening of the fiscal adjustment horizon, all else being equal, implies short-term output costs—suggesting that sharp tightening measures should be held back until private demand has reached sustainable levels. • The risk to short-term output growth is largest in the case of investment cuts, although these would also generate the strongest long-term welfare gains. From an economic perspective, tax increases would provide a less risky instrument to achieve fiscal consolidation in the initial phase of an upswing. Investment cuts could then be phased in more gradually, depending on the progress of the recovery.17 15In MULTIMOD, the public capital stock is not part of the production function— that is, public investment does not raise economic output over the long term. Economic gains of lower public investment could be somewhat overstated as a result. 16Gains in private wealth are positive even in the case of tax increases, because they include discounted future earnings, which are higher if GDP increases relative to baseline. 17This is consistent with the view that public works have actually substituted for fiscal stabilizers in the recent past, and thus should be reduced only gradually in an economic upswing (Mühleisen, 2000a).

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Figure 7.5. Macroecomonic Effects of Social Security Reform (Difference from baseline scenario; percent)

1.5

Benefit cuts Benefit cuts (high LS reaction)

VAT financing VAT financing (high LS reaction)

Real GDP 1.0 0.5 0 –0.5 –1.0 2000

10

20

30

40

50

60

70

30

40

50

60

70

30

40

50

60

70

3.0 2.5

Real Private Consumption

2.0 1.5 1.0 0.5 0 –0.5 –1.0

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2000

10

20

3 Real Private Wealth1 2

1

0

–1 2000

10

20

Source: IMF staff calculations. 1Real financial assets plus discounted real income over the projection period.

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• In terms of taxation measures, the simulations indicate that a consumption tax increase would have somewhat less beneficial effects than a broadening of the direct tax base. This highlights the fact that the VAT—although generally considered to be close to an optimal tax—does carry distortionary effects as it introduces a wedge between producer and consumer prices that is captured in MULTIMOD. The model suggests that efficiency losses from base broadening (which could result from lower tax exemptions) are smaller, although only by a small margin.

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How to Address the Aging Problem? The debate over social security reform in Japan has focused mainly on two questions. First, to what extent should future benefits be cut, and second, how can the rise in social security benefits associated with population aging be financed? These questions, however, are related, as it is generally agreed that significantly higher payroll taxes (as in the baseline scenario) would have undesirable effects on work incentives and labor costs, which indicates the need either to reduce future benefit levels or to examine alternative financing means, including higher indirect taxes. • Benefit cuts. There have been various suggestions in the literature and in the public arena to cut net benefits, including through cuts in the gross replacement ratio, higher taxation of pension incomes, and an increase in the retirement age. Potentially large savings could be achieved by shifting all remaining pension components from wage to price indexation (including National Pension benefits and entry levels of earnings-related pensions; Yashiro, Oshio, and Matsuya, 1997). An increase in the retirement age would also contribute to overall labor supply and output, but this effect is likely to be small as the participation rate of elderly Japanese in the labor force is already quite high.18 • Higher consumption taxes. Raising indirect taxes would avoid some of the disadvantages associated with higher pension contributions (and health insurance premiums) and spread the burden of financing social security benefits over the general population (including pensioners themselves). Therefore, there have been suggestions to increase transfers from the general government to the pension system, financed through higher consumption tax revenue. 18There have as yet been no studies on the extent to which health benefits would need to be reduced to avoid an increase in health insurance contributions.

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This debate is reflected in the following two simulations. First, one scenario assumes a reduction of social security benefits by 2 percent of GDP over a period of 20 years relative to the baseline scenario, which would allow a commensurate decline in social security contributions (for simplicity, the cuts could be in either pension or health benefits, or both). The second scenario keeps social security benefits unchanged relative to the baseline, but assumes that consumption taxes would be raised to finance a reduction in social security contributions identical to that in the first scenario. In this way, the scenarios analyze the tradeoff between the level of social security benefits and consumption tax increases that appears to be at the heart of the pension debate in Japan.19 The results suggest that benefit reductions, coupled with a decline in social security contributions, would clearly offer the most beneficial reform alternative with regard to both growth and economic welfare measures.20 Figure 7.5 shows that both simulated reforms would result in higher long-term growth relative to the baseline, although the effects would be larger in the case of benefit reductions. While benefit cuts would imply a short-term output decline (owing to a drop in consumption as forward-looking agents would immediately increase saving for retirement age), the positive long-term effects on output would be substantially larger, owing to a fall in interest rates that would provide a boost to investment.21 In the case of a consumption tax increase, private saving would decline relative to baseline, since the pension financing would be partly shifted from workers to pensioners who generally have a lower marginal propensity to save. Higher growth over the long term would thus mainly be an effect of increased labor supply as a consequence of lower payroll taxes.22 In contrast to benefit cuts, a reduction in social security contributions financed by a consumption tax increase would have mixed effects 19The

assumptions also imply that the social security balance in both scenarios is identical to that in the baseline. 20The two scenarios have been estimated with two different female labor supply reactions. On the basis of time-series regressions, female labor supply elasticity with respect to disposable income was estimated at 0.1. For illustration, the figures also show the simulation results for an elasticity twice that size. Except for the labor supply effects, the first scenario is identical to that presented in Chapter 6 of this book. 21As a result of rational expectations, the intertemporal pattern is likely exaggerated by the model as long-term policy changes are immediately reflected in agents’ decision making. Indeed, substantive pension reforms could have beneficial effects on output, owing to improvements in confidence as the social security system would be more plausibly funded, although such an effect is not captured in the MULTIMOD framework. 22As pointed out in the literature survey, benefit cuts would also be the most equitable way of distributing the pension burden across generations.

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on private consumption and wealth. The initial decline in saving implies that interest rates rise and that there is less of a buildup in capital stock compared with the baseline (which translates into a valuation loss of financial assets and thus lower wealth). Moreover, the increase in interest rates leads elderly consumers—who are less liquidity constrained—to increase consumption, thus further reducing aggregate saving.23 The resulting decline in the current account surplus also depresses financial wealth through a drawdown of foreign assets. Eventually, the fall in wealth would imply that consumption would drop relative to baseline, although this would only occur toward the end of the projection period. Although the results may depend to some extent on the particular specification of the model, the main policy conclusion is that a reduction of social security benefits would generate lasting output and welfare gains, albeit at the risk of some small short-term output losses that would need to be minimized through careful phasing. By contrast, financing social security through an increase in the consumption tax would also result in output gains relative to payroll tax financing, but beneficial welfare effects would not be permanent.

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Conclusions This chapter illustrates the difficult situation facing Japanese fiscal policy in the years ahead. On the one hand, high public debt and adverse population dynamics increasingly constrain the government’s room for maneuver, suggesting that strong policy adjustments will eventually be required to put public finances back on a sustainable footing. Reforms currently implemented by the government are a step in the right direction, but further measures in both the pension and health systems will be needed to avoid a large increase in payroll taxes and government transfers that would distort incentives and harm economic growth. On the other hand, the model’s simulation results suggest that ambitious debt stabilization, particularly through cuts in public investment and other expenditure, and further reductions in social security benefits could result in substantial short-term output costs, posing a risk to the recovery. This is particularly true in the case of public investment cuts, where the multipliers are generally believed to be larger. Therefore, as 23MULTIMOD is set up in a way that the income effect of higher interest rates on saving significantly exceeds the substitution effect. This is consistent with the large reliance of elderly Japanese households on accumulated assets for retirement income.

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long as private demand remains fragile, fiscal adjustment policies would have to be implemented cautiously. However, in view of the serious aging problem, once the recovery is on a sound footing, Japan will need to implement a long-term fiscal strategy that will return the public finances to a sustainable position. This chapter suggests that public investment cuts, base-broadening measures for income taxes, some increase in the consumption tax, and reductions in social security benefits are likely to be the key building blocks of the longer-term solution.

References Aaron, Henry J., Barry P. Bosworth, and Gary T. Burtless, 1989, Can America Afford to Grow Old? Paying for Social Security (Washington: Brookings Institution). Auerbach, Alan J., and Laurence J. Kotlikoff, 1987, Dynamic Fiscal Policy (Cambridge: Cambridge University Press). Chand, Sheetal K., and Albert Jaeger, 1996, Aging Populations and Public Pension Schemes, IMF Occasional Paper No. 147 (Washington: International Monetary Fund).

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Faruqee, Hamid, Douglas Laxton, and Steve Symansky, 1997, “Government Debt, Life-Cycle Income, and Liquidity Constraints: Beyond Approximate Ricardian Equivalence,” Staff Papers, International Monetary Fund, Vol. 44 (September), pp. 374–82. Hviding, Ketil, and Marcel Mérette, 1998, Macroeconomic Effects of Pension Reforms in the Context of Ageing Populations: Overlapping Generations Model Simulations for Seven OECD Countries, OECD Economics Department Working Paper No. 201 (Paris: Organization for Economic Cooperation and Development). Kohl, Richard, and Paul O’Brien, 1998, The Macroeconomics of Ageing, Pensions and Savings: A Survey, OECD Economics Department Working Paper No. 200 (Paris: Organization for Economic Cooperation and Development). Laxton, Douglas, and others, 1998, MULTIMOD Mark III: The Core Dynamic and Steady-State Models, IMF Occasional Paper No. 164 (Washington: International Monetary Fund). Leibfritz, Willis, and others, 1995, Ageing Populations, Pension Systems and Government Budgets: How Do They Affect Saving? OECD Economics Department Working Paper No. 156 (Paris: Organization for Economic Cooperation and Development). Masson, Paul R., and Ralph W. Tryon, 1990, “Macroeconomic Effects of Projected Population Aging in Industrial Countries,” Staff Papers, International Monetary Fund, Vol. 37 (September), pp. 453–85.

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Meredith, Guy, 1995, “Alternative Long-Run Scenarios,” in Saving Behavior and the Asset Price “Bubble” in Japan: Analytical Studies, ed. by Ulrich Baumgartner and Guy Meredith, IMF Occasional Paper No. 124 (Washington: International Monetary Fund), pp. 46–50. Mühleisen, Martin, 2000a, “Too Much of a Good Thing? The Effectiveness of Fiscal Stimulus,” in Post-Bubble Blues: How Japan Responded to Asset Price Collapse, ed. by Tamim Bayoumi and Charles Collyns (Washington: International Monetary Fund), pp. 107–142. ———, 2000b, “Sustainable Fiscal Policies for an Aging Population,” in Japan: Selected Issues, IMF Staff Country Report No. 00/144 (Washington: International Monetary Fund), pp. 28–57. Organization for Economic Cooperation and Development, Japan, 1997, OECD Economic Surveys, 1996–1997 (Paris). ———, 1998a, Maintaining Prosperity in an Ageing Society (Paris). ———, 1998b, The Macroeconomic Implications of Ageing in a Global Context (Paris). Oxley, Howard, and others, 1995, New Directions in Health Care Policy, OECD Health Policy Studies No. 7 (Paris: Organization for Economic Cooperation and Development). Roseveare, Deborah, and others, 1996, Ageing Populations, Pension Systems and Government Budgets: Simulations for 20 OECD Countries, OECD Economics Department Working Paper No. 168 (Paris: Organization for Economic Cooperation and Development). Takayama, Noriyuki, 1998, The Morning After in Japan: Its Declining Population, Too Generous Pensions and a Weakened Economy (Tokyo: Maruzen).

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———, and Yukinobu Kitamura, 1999, “Lessons from Generational Accounting in Japan,” American Economic Review, Vol. 89 (May), pp. 171–80. ———, and Hiroshi Yoshida, 1998, Generational Accounting in Japan, Institute for Monetary and Economic Studies, Bank of Japan, Discussion Paper No. 98–E–1 (Tokyo: Bank of Japan). Yashiro, Naohiro, and Akiko Sato Oishi, 1997, “Population Aging and the SavingsInvestment Balance in Japan,” in The Economic Effects of Aging in the United States and Japan, ed. by Michael D. Hurd and Naohiro Yashiro (Chicago: University of Chicago Press). Yashiro, Naohiro, Takashi, Oshio, and Mantaro Matsuya, 1997, Macroeconomic and Fiscal Impacts of Japan’s Aging Population with a Specific Reference to Pension Reforms, Economic Research Institute, Economic Planning Agency, Discussion Paper No. 78 (Tokyo: Economic Planning Agency). World Bank, 1994, World Population Projections: 1994–95 (Baltimore, Maryland: Johns Hopkins Press).

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8 Fiscal Policy: An Evaluation of Its Effectiveness SANJAY KALRA

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T

he persistence of slow growth in the 1990s despite rising structural budget deficits has led to a debate on the effectiveness of fiscal policy in Japan. A number of observers have questioned whether fiscal policy can provide even a short-term stimulus to economic activity. For example, a recent survey by Hemming, Mahfouz, and Shimmelpfennig (2002) concludes that fiscal multipliers in industrial countries are small, while OECD (2000) suggests that fiscal multipliers in Japan declined significantly during the 1990s. In contrast, however, Kuttner and Posen (2001) obtained large tax and aggregate spending multipliers, and noted that the “real water” content of the stimulus packages of the 1990s—that is, the proportion of the packages that has a direct impact on activity—was actually small, implying that a more aggressive fiscal policy could have moderated recessions. Against this background, this chapter empirically examines the impact of budgetary policies on real activity during the 1990s. It uses a structural vector autoregression (SVAR) framework to estimate dynamic fiscal multipliers. Fiscal multipliers are estimated for general government revenue and expenditure, and separately for different components of government spending. Multipliers are also estimated for the period 1961–80. These multipliers help to gauge the effectiveness of fiscal policy during the 1990s and the factors that had an impact on it. The SVAR framework has been used to derive fiscal multipliers for the United States by Blanchard and Perotti (1999) and for Japan by Kuttner and Posen (2001). It has also been used to study the effects of 164

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the composition of government spending for the United States by Fatás and Mihov (2001) and for the United Kingdom by Escolano (2002). The key results of this chapter are as follows. First, revenue declines and rising social security payments, rather than increases in government investment, played a key role in the deterioration in the fiscal position during the 1990s. Second, fiscal policy has a continued role in countercyclical aggregate demand management as short-run fiscal multipliers do not appear to have changed much. Third, however, the results do suggest that fiscal multipliers at longer horizons are now significantly smaller owing to a decline in spending multipliers for both government investment and consumption spending.

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Fiscal Policy in the 1990s Contrary to conventional wisdom, revenue declines and increases in current spending contributed more to the deterioration in the structural balance during the 1990s than the investment spending in the stimulus packages. Overall, with the exception of FY1997, when general government investment expenditures were reduced, the structural balance is estimated to have deteriorated steadily from a surplus of about 1!/2 percent of (potential) GDP in FY1990 to about 6 percent in FY2000 (Figure 8.1). Of this total change, 3 percentage points of GDP were due to a decline in structural revenues and the remaining 4!/2 percentage points of GDP, to an increase in structural expenditures. The decline in structural revenues is attributable to a substantial reduction in the tax base, on account of both the tax cuts that were provided as part of the stimulus packages and the decline in the effective corporate tax rate from nearly 50 percent in 1990 to about 40 percent in the late 1990s (Mühleisen, 2000). The bulk of the increase in structural expenditures is accounted for by an increase in current expenditure. Of the total increase in structural expenditures, 3!/2 percentage points of GDP was due to higher current expenditures, all of which was attributable to an increase in social security benefit payments. The remaining increase of 1 percentage point of GDP was due to capital expenditure. Of this, almost none of the increase in capital expenditure was attributable to general government fixed investment; all of the increase was due to government spending on land acquisition and capital transfers. Government investment spending rose only modestly from 5 percent of GDP in FY1990 to 6!/4 percent of GDP in FY1996, before falling back to 5 percent of GDP in FY2000. Adverse debt dynamics also contributed significantly to an increase in deficits and the level of public debt (van den Noord, 2000). It

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Figure 8.1. Changes in the Structural Balance, 1990–2000 Percent of potential GDP 38 Structural Balance 36 Expenditure (left scale)

34 32 30

Standardized revenue Structural balance (left scale) (right scale)

28 26 FY

0

9 19

2

9 19

FY

4

9 19

FY

6

9 19

FY

8

9 19

FY

0

0 20

4

30

2

25

0

20

–2

15

–4

10

–6

5

–8

0

Social security premiums

Taxes and fines

90

19

92

19 FY

94

19

FY

98

96

19

FY

19

FY

00

20

FY

Percent of potential GDP 40 Composition of Current Expenditure 35

Capital

30

Interest paid and other

25

25

20

20 Current

15

10

5

5

0

0

9 19

4

2

FY

9 19

FY

9 19

6

FY

9 19

Social security benefits

15

10

FY

Other revenue

FY

FY

Percent of potential GDP 40 Expenditure 35 30

6

Percent of potential GDP 40 Standardized Revenue 35

8

8

FY

9 19

0

FY

0 20

0

Consumption 90

19

FY

94

92

19 FY

19

FY

96

19

FY

98

19

FY

00

20

FY

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Source: IMF staff calculations.

is noteworthy that, on the back of a significant expansion of benefits in the mid-1970s, the social security balance, excluding budgetary transfers, had already swung into a deficit in the early 1980s (Figure 8.2). (This shift in the social security finances provides a rationale for splitting the sample at 1981 in the empirical work that follows.) The “real water” content of the stimulus packages in the 1990s was small. While the stimulus packages—consisting predominantly of spending on public works projects, but also including tax cuts, land acquisition, and on-lending by government financial institutions—came with large headline figures (a total of ¥136 trillion between 1990 and 2000), the “real water” measures—tax cuts and public works—were less than 50 percent of the total. The bulk of the tax cuts, primarily in the form of personal and corporate income tax cuts, were instituted in

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Figure 8.2. Social Security Balance and Old-Age Dependency Ratio Trillions of yen, real 2

Percent 36

1

32

0

28

–1

24 Social security balance (left scale)1

–2

20

–3

16

–4

Old-age dependency ratio (right scale)

12

–5

8

–6 1961

65

70

75

80

85

90

95

2000

4

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Sources: National Income Accounts; Ministry of Health, Labor, and Welfare; and IMF staff estimates 1Excluding transfers.

1998, after the consumption tax hike of 1997. Moreover, the public investment allocations, estimated at about 1!/4 percent of GDP a year, translated into a substantially smaller annual increase in general government investment of only #/4 percent of GDP, in part owing to financing difficulties at the local government level. All in all, the effective tax cut and public works components of the stimulus packages—the “discretionary” element of fiscal policy in the 1990s—were substantially smaller than the headline figures and as a share of GDP (Figure 8.3). Macroeconomic conditions dampened the impact of fiscal policy. Monetary conditions appear to have tightened since 1998. Real interest rates, which had been on a declining trend since the early 1990s, rose as the zero nominal interest rate bound was hit and deflationary conditions began to take hold. The real exchange rate also appreciated significantly starting in mid-1998.

Structural VARs and Fiscal Multipliers A baseline SVAR was estimated to obtain aggregative fiscal multipliers. This vector autoregression (VAR) was estimated using quarterly data for the sample period 1981–2000. The five variables included in the VAR were general government spending (the sum of consumption and investment spending), revenues (the sum of direct and indirect revenues), the real interest rate, the real effective exchange rate, and

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Figure 8.3. Stimulus Packages, 1990–2000 (Trillions of yen) 30 Tax cuts Public works

25

Other public investment Other

20 15 10 5 0

1993 first half

1992

1993 second half

1994

1995 first half

1995 second half

1998 first half

1998 second half

1999

2000

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Sources: Ministry of Finance; and IMF staff estimates.

the output gap. To separately identify the impact of the social security system, social security contributions and benefit payments were excluded from the revenue and expenditure variables, and multipliers for social security payments were estimated separately. This separation also permits an examination of social security payments on multipliers for other government spending. The sources, transformations, and statistical properties of the data are as follows. Real government spending and real activity data are from the national income accounts. The real interest rate is computed using the Bank of Japan’s discount rate and the change in the GDP deflator. The real effective exchange rate is the IMF’s multilateral real exchange rate using the relative change in CPI between Japan and partner countries. The output gap was derived from real output using a Hodrick-Prescott filter. The revenue variable was converted into real terms using the GDP deflator. Based on the stationarity properties of the variables, all variables except the output gap and the real interest rate were used in first differences of log levels in the estimation. To obtain the dynamic fiscal multipliers, the elasticities generated by the cumulative impulse response functions of the baseline VAR were evaluated at the mean value of the ratio of the fiscal variable to output for the sample period. The baseline structural VAR takes the form m

Ayt = ∑Miyt–i + Nxt + εt, i=1

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(1)

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where yt is a vector of five variables, m is the maximum lag of the state variable, xt is a vector of exogenous variables, and εt are the orthogonal, structural shocks. The matrix A is the identity matrix minus the matrix of contemporaneous effects of state variables (A0), and M and N are coefficient matrices. The reduced form VAR conforming to this structural VAR is m

yt =∑Diyt–i + Fxt + et,

(2)

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i=1

where et represents reduced-form, non-orthogonal error terms. Identification restrictions were used to obtain structural parameters and shocks from the estimated reduced form VAR. Along the lines of Blanchard and Perotti (1999), based on a priori information about the budget process and informational lags, the following short-run restrictions were imposed on the contemporaneous cross-effects of endogenous variables. (1) Government spending is not affected by other variables. This is plausible on the grounds that as part of the budget implementation process, once the budget allocations have been set, government spending is unlikely to be affected by the real interest rate, the real effective exchange rate, and revenues, while lags in data compilation imply that government spending is unlikely to be affected by the output gap for the quarter; (2) The interest rate is assumed to be unaffected by other variables; (3) The real effective exchange rate is affected by government spending and the real interest rate; (4) Revenues are affected only by the output gap; and (5) The output gap is affected by government spending. Together with suitable supplementary restrictions on the contemporaneous impact of structural shocks on endogenous variables, the VAR is exactly identified.

Effectiveness of Fiscal Policy Estimates from the baseline SVAR indicate that aggregative (dynamic) fiscal multipliers were broadly centered around !/2 during 1981–2000. Spending multipliers (represented as the impact at lagged quarters of a ¥100 increase in government spending on the output gap; see Figure 8.4) estimated from the baseline VAR peaked after two quarters at about ¥40, and were effectively zero after three years. Compared with the sample period 1961–80, these multipliers were similar over short horizons. However, over longer horizons, the multipliers appear to have declined substantially compared with large positive multipliers in

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Figure 8.4. Spending Multipliers, 1961–2000 (Cumulative impact on output of a ¥100 increase in government spending) Yen 350 300 250

1961–80

200 150 100 50

1981–2000

0 –50

1

2

3

4

5

6

7

8

9

10 11 12 13 14 15 16 17 18 19 20

Lagged quarters

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Source: IMF staff estimates.

the earlier period. As regards tax multipliers, a tax cut of ¥100 is estimated to have led to an increase in output of about ¥40–50 in the short term, but the effect wears off to ¥30 after 20 quarters, and is similar to the output effect during the earlier sample period. These results are broadly comparable to other studies. For example, spending multipliers from macroeconomic models for Japan range between –!/2 and 3 (similar to those for the United States and Germany). Bayoumi (2000) obtains short-term spending and revenue multipliers of 0.65 and 0.2, respectively, for 1981–98 using a VAR framework. Considerable attention has been devoted to inefficiencies in public works and the high level of public debt as factors behind the decline in long-run spending multipliers. On public investment, the argument from the supply side has been that it was cost ineffective and generated a low rate of return. From an aggregate demand perspective, the argument is that the public investment in the 1990s did not evoke enough of a complementary response from private investment, although this has not been verified directly. The role of public debt in dampening private consumption has also been cited. However, a recent study that estimates the marginal propensity to consume (mpc) out of household income directly as a time-varying function of fiscal variables does not find a clear relationship between mpc and the government debt-toGDP ratio (Bhattacharya, 1999). Moreover, public debt has been on a rising trajectory since at least the 1970s, initially on account of an expansion of social benefit payments and since the early 1980s owing to

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changing demographics, especially a rapid increase in the old-age dependency ratio. Much less attention has been paid to other factors. As noted above, demographics had already led to deficits in the social security system starting in the early 1980s. These developments marked an important shift in the composition of government spending and, potentially, its impact on real activity. For one, different components of government spending, taxes, and transfers have different effects on activity as their incidence varies across agents with different propensities to consume. Most existing studies estimate fiscal multipliers including social security payments either in government spending or more commonly, lump them together with revenues (as negative taxes). From an empirical standpoint, this imposes a restriction that the multipliers for social security spending are the same (in absolute value) as for other components of government spending and taxes. This need not be the case. Escolano (2002) finds, for example, that multipliers for social transfers are larger than for taxes for the United Kingdom, thus rejecting the restriction that tax and transfer multipliers are equal. Along these lines, the role of the composition of government spending was examined by suitably augmenting the baseline SVAR, and multipliers for social security spending were estimated separately. Lower fiscal multipliers for both government consumption and investment spending contributed to the decline in long-run aggregative spending multipliers. The baseline VAR specification was reestimated with government spending broken down into consumption and investment spending, and the expenditure multipliers were estimated separately for the two components. For the period 1981–2000, consumption and investment spending multipliers were about 0.45 and 0.65, respectively, after two quarters (Figure 8.5). Over longer horizons, however, the consumption multipliers were actually negative, while the investment multipliers were much smaller although still positive. While the decline in the investment multiplier has been widely noted in the literature—see, for example, Yoshino and Sakakibara (2002)—there has been little discussion of consumption multipliers. The decline in the multipliers could be attributable to a change in the composition of government spending. The shift in the composition of non–social security spending is reflected in the rise in the share of health expenditures, which rose by over 10 percent from 26!/4 percent during 1970–80 to 36!/2 percent during 1980–97 (Table 8.1). This change in the composition of non–social security government spending paralleled the increase in social security spending, with both spurred by population aging. The impact of this shift can be estimated by aug-

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Figure 8.5. Disaggregated Spending Multipliers, 1961–2000 (Cumulative impact on output of a ¥100 increase in government spending) Yen 500 Investment, 1961–80

400

Consumption, 1961–80

300 200 100

Investment, 1981–2000

0 –100 –200

Consumption, 1981–2000 1

2

3

4

5

6

7

8

9

10 11 12 13 14 15 16 17 18 19 20

Lagged quarters

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Source: IMF staff estimates.

menting the SVAR to include social security payments as a proxy for the composition of government spending and comparing the estimated fiscal multipliers on government spending with those from the baseline VAR. The augmented SVARs suggest that the shift in the composition of government spending and rising social security payments dampened the long-run output effects of fiscal policy. The estimated government spending multipliers from the augmented VAR for 1981–2000 were higher compared with the baseline VAR (Figure 8.6). These results indicate that, for given budgetary expenditures, the shift in the composition of government spending toward social security–related expenditures had a negative output effect. It also highlights the role of Table 8.1. Functional Classification of Government Spending, 1970–971

Education Health Economic services General public services Housing and community Defense Other Total

1970–80

1981–97

31.3 26.2 40.1 21.6 14.2 6.0 2.5

25.5 36.5 33.4 21.4 18.0 6.0 4.6

100.0

100.0

Source: Ishi (2000). 1Excluding social security and welfare payments.

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Figure 8.6. Spending Multipliers, 1981–2000 (Cumulative impact on output of a ¥100 increase in government spending) Yen 50 40 30 20

Augmented VAR

10

Baseline VAR

0 Social security

–10

1

2

3

4

5

6

7

8

9

0 11 12 13 14 15 16 17 18 19 20

Lagged quarters

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Source: IMF staff estimates.

aging in dampening the effect of government spending through the transmission mechanism. This channel of transmission is reflected in the larger elasticities of non–social security government spending relative to social security spending: as budgetary pressures due to demographics became acute starting in the early 1980s, social security payments squeezed other government spending more than in the earlier period. Moreover, the estimated multipliers for social security spending were essentially zero over the short term and over longer horizons. These demand-side explanations for the adverse effects of social security spending on output are complemented by supply side explanations. Cross-country comparisons suggest that there are a number of inefficiencies in the provision of health services in Japan (OECD, 2001). These inefficiencies are related to the cost ineffectiveness of the current health care system. For example, the fee-for-service system generates a high number of outpatient consultations per capita per year (more than twice the OECD average) and higher drug consumption. The decline in long-run multipliers is also attributable to weaker “crowding in” effects of government spending. In this context, it is again useful to distinguish between the supply- and demand-side effects of public investment in particular. The public works projects of the 1990s expanded social infrastructure and capacity—mostly related to agriculture and rural road creation. The estimated return to public capital in these projects and sectors is low compared with those in tertiary sector industries and in large urban-based prefectures where comple-

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Figure 8.7. Impact on Private Investment, 1961–2000 (Cumulative impact on output of a ¥100 increase in government spending) Yen 200 1961–80

150 100 50 0

1981–2000

–50

1

2

3

4

5

6

7

8

9

10 11 12 13 14 15 16 17 18 19 20

Lagged quarters

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Source: IMF staff estimates.

mentarities between public and private investment are higher (Yoshino and Nakahigashi, 2000). However, their demand-side impact was also limited. This is reflected in the weaker “crowding-in” effects of government spending as shown by SVARs in which the output gap was replaced by private investment spending. The estimated multipliers from these SVARs suggest that government investment had a substantial positive effect and “crowded in” private investment during 1961–80 (Figure 8.7). However, during 1981–2000, the standard “crowding out” effect was more prominent and the effect of government spending shocks on private investment was small and negative. This negative impact is attributable, in part, to the shift in the financial condition of the banking and the corporate sectors, which impeded the fiscal transmission mechanism during the latter sample period as suggested by Bayoumi (2000) and Ogawa and others (1996). Controlling for the effect of these factors using bank lending as a proxy in augmented VARs, government spending multipliers were higher.

Policy Implications This chapter’s analysis has the following implications for the conduct of fiscal policy. First, there remains a role for fiscal policy as an instrument of countercyclical demand management. The analysis in the chapter shows that short-run spending multipliers on non–social security spending and tax cuts during 1981–2000 were broadly the same as

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in an earlier sample period, although the multipliers were lower at longer horizons. Although long-run multipliers appear to be smaller, government spending increases and tax cuts can still help support aggregate demand in the short run. There also appears to be support for the view that the “real water” content of the stimulus packages of the 1990s was small. A large portion of the increase in the budget deficit and public debt was due to higher social security spending to meet rising demographic pressures. Such spending is estimated to have had lower impact on output than other government spending or tax cuts. Second, fiscal policy can be made more effective. Setting the fiscal policy stance in initial budgets, and reducing dependence on stop-go supplementary budgets, could help smooth fiscal stimulus during downturns. An improvement in the composition of government expenditure would also make fiscal policy more effective. Government investment spending needs to be shifted to sectors and geographical locations where it has a higher rate of return and complementarities between government and private spending are higher. While pressures for higher social security spending are likely to persist over the foreseeable future, the impact on output could be enhanced through improved efficiency, especially in the health sector.

References

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Bayoumi, Tamim, 2000, “The Morning After: Explaining the Slowdown in Japanese Growth,” in Post-Bubble Blues: How Japan Responded to Asset Price Collapse, ed. by Tamim Bayoumi and Charles Collyns (Washington: International Monetary Fund), pp. 10–44. Bhattacharya, Rina, 1999, “Private Sector Consumption Behavior and Non-Keynesian Effects of Fiscal Policy,” IMF Working Paper 99/112 (Washington: International Monetary Fund). Blanchard, Olivier Jean, and Roberto Perotti, 1999, “An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output,” NBER Working Paper No. 7269 (Cambridge, Massachusetts: National Bureau of Economic Research). Escolano, Julio, 2002, “The Macroeconomic Effects of U.K. Fiscal Policies: An Empirical Exploration,” United Kingdom: Selected Issues, IMF Country Report No. 02/46 (Washington: International Monetary Fund), pp. 5–20. Fatás, Antonio, and Ilian Mihov, 2001, “The Effects of Fiscal Policy on Consumption and Employment,” CEPR Working Paper No. 2760 (London: Centre for Economic Policy Research).

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Hemming, Richard, Selma Mahfouz, and Axel Shimmelpfennig, 2002, “Fiscal Policy and Economic Activity During Recessions in Advanced Economies,” IMF Working Paper 02/87 (Washington: International Monetary Fund). Ishi, Hiromitsu, 2000, Making Fiscal Policy in Japan: Economic Effects and Institutional Setting (Oxford: Oxford University Press). Kuttner, Kenneth, and Adam S. Posen, 2001, “The Great Recession: Lessons from Macroeconomic Policy from Japan,” Brookings Papers on Economic Activity: 2, Brookings Institution. Mühleisen, Martin, 2000, “Too Much of a Good Thing? The Effectiveness of Fiscal Stimulus,” in Post-Bubble Blues: How Japan Responded to Asset Price Collapse, ed. by Tamim Bayoumi and Charles Collyns (Washington: International Monetary Fund), pp. 107–42. OECD, 2000, OECD Economic Surveys, 1999–2000: Japan (Paris: Organization for Economic Cooperation and Development). ———, 2001, OECD Economic Surveys, 2000–2001 (Paris: Organization for Economic Cooperation and Development). Ogawa, Kazuo, Shin-ichi Kitasaka, Hiroshi Yamaoka, and Yasuharu Iwata, 1996, “Borrowing Constraints and the Role of Land Asset in Japanese Corporate Investment Decision,” Journal of the Japanese and International Economies, Vol. 10 (June), pp. 122–49. Yoshino, Naoyuko, and Eusike Sakakibara, 2002, “The Current State of the Japanese Economy and Remedies,” Asian Economic Papers, Vol. 1, No. 2. Yoshino, Naoyuko, and Masaki Nakahigashi, 2000, “Economic Effects of Infrastructure—Japan’s Experience After World War II,” JBIC Review, Vol. 3 (December), pp. 3–19.

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van den Noord, Paul, 2000, “The Size and Role of Automatic Fiscal Stabilisers in the 1990s and Beyond,” OECD Working Paper No. 230 (Paris: Organization for Economic Cooperation and Development).

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IV

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MONETARY AND EXCHANGE RATE POLICY IN JAPAN

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9 The Zero-Interest-Rate Floor and Its Implications for Monetary Policy in Japan BEN HUNT AND DOUGLAS LAXTON

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I

n 1991 Larry Summers predicted that the issue of the zero-interestrate floor (ZIF) would become of central importance to monetary policy in an era of low inflation. He cautioned that the scope for adjusting the stance of monetary policy could become severely constrained if the monetary authorities pursued a very low inflation rate because such a choice would result in a low average level of nominal interest rates. Specifically, in a period where interest rates were already at low levels the ZIF might significantly reduce the monetary authority’s scope to reduce real interest rates when its output and inflation stabilization objectives were threatened by adverse deflationary shocks to the economy. Not surprisingly, given the events in Japan in the 1990s, considerable research effort has been devoted to the implications of the ZIF. This work has followed two different tracks. The first track has examined what other policy channels, besides the short-term nominal interest rate, are available to stimulate the economy once the ZIF becomes binding.1 The second track has investigated how the design of the monetary policy framework (as summarized by policy rules and the choice of the target rate of inflation) can affect the probability that the ZIF will 1See

Krugman (1998a, 1998b), Buiter and Panigirtzoglou (2000), Clouse and others (2000), and Svensson (2001).

179

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become a binding constraint on policy.2 The work presented in this paper follows along both these tracks. One major difference, however, is that rather than using a closed-economy model to investigate this issue, this paper employs the Japan block of MULTIMOD, the IMF’s multicountry macroeconomic model.3 Following along the research track that examines policy channels other than the short-term nominal interest rate, we consider one-off fiscal and monetary policy interventions designed to help stimulate the economy after persistent negative shocks have pushed interest rates down to the ZIF. We consider an increase in government spending because expansionary fiscal policy is often argued to be an effective means of stimulating the economy once monetary policy has become less effective as a result of the ZIF. The first monetary policy intervention that we consider is a credible commitment by the monetary authority to restore any decline in the price level that has occurred because the shortterm nominal interest rate has been constrained by ZIF. This monetary policy intervention can be thought of as a commitment to future inflation. This solution is suggested in Krugman (1998a, 1998b) and is examined in Reifschneider and Williams (1999). The second monetary policy intervention involves a sharp depreciation in the nominal exchange rate coupled with a credible commitment to achieve a specified price-level target over the medium term. This monetary policy approach to the problem of the ZIF is proposed in Svensson (2001).4 The one-off fiscal and monetary policy interventions that we consider are effective in stimulating the economy once the ZIF has become binding. These interventions reduce the length of time that the constraint binds and thereby reduce the output loss incurred. However, important differences arising in the evolution of the government’s debt-to-GDP ratio make monetary-policy-based interventions more attractive; in both of the monetary-induced interventions, the government’s debt-to-GDP ratio is lower than in the scenario where the intervention is based on a fiscal expansion. This is because monetary policy–based interventions work through inflation expectations, thereby stimulating private demand by reducing expected real interest 2See Lebow (1993), Laxton and Prasad (2000, 2001), Fuhrer and Madigan (1997), Meredith (1999), Orphanides and Wieland (1998, 2000), and Reifschneider and Williams (1999). 3Most of the research in this area has relied upon either simple closed-economy models or models that have been approximately closed. 4In Hunt and Laxton (2001), the efficacy of increasing the target rate of inflation to stimulate the economy once the ZIF becomes binding is also examined, as is the implication of uncertainty about potential output.

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rates. In these cases, revenue increases because of the increase in private demand, and service costs on the existing stock of governmentdebt fall because of the reduction in real interest rates. Following the second research track, we use the Japan block of MULTIMOD to investigate the implications of the ZIF for the design of systematic monetary policy in Japan. We first consider how the choice of the target rate of inflation influences the likelihood of the ZIF becoming binding and the magnitude of the deterioration in macroeconomic performance that results. For this initial step we use a basecase inflation-targeting policy rule similar to the Taylor rule.5 We then consider how the base-case policy rule can be modified to mitigate the ZIF implications. The modifications include the strength of the policy response to deviations of forecasts of inflation from target and output from potential output as well as adding a price-level component to the rule. Incorporating a price-level component into the policy rule is in the spirit of the approaches suggested in Reifschneider and Williams (1999) for compensating for the time that interest rates are constrained by the ZIF. Consistent with the findings in other studies, the simulation analysis presented in the paper suggests that target rates of inflation below 2.0 percent significantly increase the probability that the zero constraint will become binding and that macroeconomic performance will suffer. The analysis suggests that there are modifications to the systematic component of monetary policy that help to mitigate the implications of the ZIF. Responding more aggressively to estimates of the output gap and forecasts of inflation, and incorporating an explicit price-level dimension into the base-case inflation-forecast-targeting rule all help to mitigate the implications of the ZIF. Of the modifications to the initial rule that are considered, we find that an asymmetric rule whereby the policymaker commits to restoring declines in the price level is the most effective. However, the results clearly suggest that the most important component in the monetary policy framework for combating the deleterious implications of the ZIF is a sufficiently high target inflation rate. 5For this initial step we use a more forward-looking rule than the original Taylor (1993) rule. Under this policy rule, the short-term nominal interest rate is adjusted, relative to a forward looking measure of the neutral short-term nominal interest rate, in response to the output gap and the gap between core inflation and the assumed target. The original Taylor (1993) rule is more backward looking than our base-case rule because the neutral nominal interest rate is not forward looking. Because of the structure of MULTIMOD (the existence of nonlinearities and multiple sources of shocks), the original Taylor rule is a relatively inefficient rule for generating low variability in both inflation and output.

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Taken together, the simulation analysis, the possible biases in price indices, and uncertainties associated with estimates of potential output and the monetary transmission mechanism suggest that, for Japan, an appropriate target rate of inflation could be as high as 2.5 percent.

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MULTIMOD MULTIMOD is a multiregional macroeconomic model developed by the IMF staff for the primary purpose of analyzing alternative scenarios for the World Economic Outlook (WEO) forecast. As such, it is based on annual data and takes the WEO forecast as an “exogenous” baseline.6 Its construction has gone through several stages. The simulations presented in this chapter are based on the current Mark III version7 and focus on the Japan block. Modern structural models like MULTIMOD have been designed to minimize first-order Lucas-critique problems and thereby provide insights on the key role of the monetary policy response in influencing the macroeconomic effects of various exogenous shocks.8 MULTIMOD analysis of the implications of the non-negativity constraint on nominal interest rates hinges critically on the nature of wageprice behavior. MULTIMOD, like most macroeconomic policy models, relies on a reduced-form Phillips curve to characterize the behavior of inflation in the industrial countries. Because MULTIMOD is used for addressing a wide range of policy questions, several versions of the model are maintained. A simple version of the model incorporates a linear Phillips curve with parameter values that are constrained to be identical for all of the industrial country blocks. However, the version of the model used for the analysis presented in this paper incorporates a more detailed model of the inflation process that allows for nonlin6For the simulations presented in this chapter, the equilibrium rates of inflation have been altered from that in the WEO baseline. 7Laxton and others (1998) describe the Mark III version of MULTIMOD; see also Isard (2000). The version used in this chapter incorporates several major changes. These changes include the incorporation of a euro area block; new base-case specifications of the behavior of monetary and fiscal policy; and a recoding of the model that more easily permits solutions to the model in which countries choose different steady-state rates of inflation. 8Changes in policy rules will have effects on expectations in MULTIMOD because expectational variables are modeled explicitly and depend on the model’s forecasts for these variables. However, MULTIMOD may not be completely immune to the Lucas critique. The Phillips curve, for example, is a reduced-form equation, and there is always the possibility that a major change in the pattern of monetary policy behavior could lead to significant changes in the nature of wage and price contracts and in the dynamics of inflation expectations.

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earities and asymmetries to arise between demand conditions and inflation.9 Further, the parameters in this formulation of the wage-price nexus are allowed to vary across the different industrial country blocks. In this version of MULTIMOD, the modeling of inflation and inflation expectations distinguishes between CPI inflation and core inflation. Core inflation is defined as the rate of change in the GDP deflator excluding oil and is taken to be the measure on which monetary policy decisions are based. Although MULTIMOD does not include explicit wage rates, the dynamics of inflation and inflation expectations are characterized in a manner that implicitly recognizes important features of wage-setting behavior (in particular, contracting lags and wage-push elements). The key equations in MULTIMOD’s reduced-form wage-price structure are CPI ; πtCPI = δ1πtM + δ2πtC + δ3πtPOIL + [ 1 – δ1 – δ2 – δ3]πt–1

(1)

CPI – πC ]; (2) πtC = ψπet+1 + [1 –ψ]πCt–1 + γ [(u*t – ut)/(ut – φt)] + α [πt–1 t–1

and

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CPI + (1 – λ)πC ] + [1 –Ω][λπ CPI + (1 – λ)πC ]; πet+1 = Ω[λπt+1 t–1 t+1 t–1

(3)

where πCPI is CPI inflation; πM is the rate of inflation of the domesticcurrency price of manufactured imports; πPOIL is the rate of inflation of the domestic-currency price of oil; πC is core inflation (non-oil GDP deflator); πe is a measure of expected inflation; u* is the nonaccelerating-inflation rate of unemployment (the NAIRU); u is the unemployment rate; φ is the minimum absolute lower bound for the unemployment rate; and ψ, α, γ, Ω, λ, δ1, δ2, and δ3 are parameters. Table 9.1 reports some of the parameter values from the model’s wageprice block as well as some associated model properties that are helpful for understanding the inflation process in the model.10 In particular, it reports estimates of the parameter values λ, α, ψ, Ω, and γ for each country/block, as well as average values for these parameters across all of the 9Allowing

for nonlinearities and asymmetries in the inflation process means that large policy errors can have first-order welfare implications. 10Equation (2) has been estimated for each of MULTIMOD’s major industrial countries/blocks as part of an unobserved components model that also includes equations for the deterministic NAIRU, the NAIRU, and an Okun’s Law relationship between the output gap and the unemployment gap. The estimation is done using the Kalman filter and a constrained-maximum-likelihood procedure. Equations (1) and (3) were estimated with ordinary least squares (OLS).

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Table 9.1. MULTIMOD Key Inflation Parameters

Average

λ

α

Ω

ψ

0.48

0.26

0.57

0.54

Ω• ψ• (1– λ) 0.16

Γ

Sacrifice Benefit Ratio1 Ratio2

2.15

—

—

United States

0.48

0.35

0.53

0.51

0.14

2.22

1.25

–1.12

Euro area

0.60

0.12

0.58

0.51

0.12

2.15

1.86

–1.61

Japan

0.31

0.09

0.60

0.59

0.25

2.29

0.80

–0.74

United Kingdom

0.34

0.42

0.60

0.58

0.23

2.38

1.02

–0.93

Canada

0.41

0.16

0.50

0.51

0.15

2.38

1.31

–1.15

Other industrial

0.74

0.42

0.60

0.55

0.09

1.45

4.10

–3.22

1The

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sacrifice ratio is the cumulative increase in the annual unemployment rate that is required to reduce inflation permanently by 1 percentage point. 2The benefit ratio is the cumulative decrease in the annual unemployment rate that is required to increase inflation permanently by 1 percentage point.

industrial country blocks. The table also presents the unemployment sacrifice and benefit ratios that result from an artificial experiment where the rate of inflation is permanently increased by 1 percentage point (benefit ratio) and permanently decreased by 1 percentage point (sacrifice ratio). The sacrifice ratio of 0.8 for Japan implies that to reduce inflation permanently by 1 percentage point, the cumulative increase in annual unemployment above the NAIRU must be 0.8 percentage points.11 Having the lowest sacrifice and benefit ratios implies that inflation is estimated to be more responsive to changes in unemployment in Japan than in other industrialized countries. This arises primarily from the interaction of the slope parameter (γ) and the weight on the model-consistent lead of core inflation (Ω• ψ• (1 – λ)) in the Phillips curve.12 All else being equal, the larger the slope coefficient (or the larger the weight on the lead of core inflation), the more responsive inflation will be to demand condi11Comparing the sacrifice and benefit ratios in each country illustrates the direction of the asymmetry in MULTIMOD’s inflation process; the cost incurred to reduce inflation is larger than the benefit that could be derived from increasing it. When the change in inflation is restricted to be only 1 percentage point, the difference between the sacrifice ratio and the benefit ratio is small. However, this relationship is nonlinear, so that as the changes in inflation that are considered become larger, the degree of asymmetry increases. 12The degree of persistence in CPI inflation also contributes to the sacrifice and benefit ratios. For example, the difference between the sacrifice ratios for Canada and the United States is a result of a larger weight on lagged CPI inflation in the Canadian price block (0.13 for Canada versus 0.03 for the United States).

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tions. It is also worth noting that the magnitudes of α and λ imply that, in Japan, movements in the exchange rate and import prices do not have a large effect on core inflation.13 The estimated sensitivity of inflation to demand conditions in Japan will play a key role in determining the implications of the ZIF. On the one hand, because of the high degree of responsiveness of inflation to demand conditions, negative shocks to aggregate demand can more easily push inflation below zero. In the face of the ZIF, this can quickly limit the monetary authority’s ability to lower real interest rates, potentially leading to a deflationary spiral. On the other hand, because forward-looking expectations play a large role in determining the responsiveness of inflation to aggregate demand conditions, a welldesigned monetary policy framework may also be able to exploit a potentially powerful transmission mechanism to overcome any deleterious implications of the ZIF. MULTIMOD’s base-case monetary policy reaction function is based on the familiar Taylor (1993) specifications. Specifically, the nominal short-term interest rate is adjusted—relative to a neutral nominal interest rate—in proportion to the deviation of current output from potential output and the deviation of inflation from target.14 In MULTIMOD, monetary policy stabilizes inflation through two main channels—direct price effects that operate through the exchange rate and import prices and indirect effects that operate via aggregate demand. When the monetary authority adjusts the short-term nominal interest rate, the real short-term interest rate moves because inflation is sticky. This movement in the real short-term interest rate affects the real exchange rate through uncovered interest parity. Because exchange-rate expectations also include backward- and forwardlooking components, the uncovered interest rate parity condition implies that the real exchange rate will respond partially in the short run to the future cumulative gap between the real domestic and foreign short-term interest rates. Movements in the real exchange rate feed into domestic CPI inflation directly through import prices. CPI infla13There

are several possible factors that may be contributing to this property. First, imports represent a relatively small portion of the consumption bundle. Second, there is a large (albeit declining) number of regulated prices. Finally, the wage-setting process in Japan is possibly more cooperative than in other industrial countries. Company profitability tends to be the most important factor underlying the variability in wages. 14The base-case reaction function used here sets the short-term nominal interest rate equal to a neutral nominal interest rate plus 0.5 times the output gap plus 1.0 times the deviation from target of the current year’s core inflation. The neutral nominal interest rate is defined as an equilibrium real interest rate plus the expected rate of inflation (as given by equation (3) above).

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tion, in turn, can feed into core inflation through expectations (λ) and the real-wage catch-up term (α). The movement in the real exchange rate also affects core inflation indirectly through aggregate demand because of its impact on the relative price of domestically produced versus foreign-produced goods. The real interest rate affects core inflation indirectly by its influence on spending on private investment and consumption goods. This arises because movements in the real interest rate alter consumers’ valuation of their human wealth, their marginal propensity to consume out of wealth, and the market value of capital relative to its replacement cost. Because of the forward-looking structure of all of the channels through which real interest rates affect inflation, both current and future expected short-term real interest rates have an important role to play. This is an important feature when examining the implications of the ZIF. Once current nominal interest rates hit the ZIF, it is through future expected real interest rates that monetary policy must operate. The central role that this channel plays in MULTIMOD makes it a potentially useful framework for examining this issue. The value of the equilibrium real interest rate is also an important variable that needs to be calibrated to study the implications of the ZIF. In the base-case version of MULTIMOD, the world equilibrium real interest rate is roughly 3 percent. However, an examination of the average real interest rate in Japan between 1970 and 2000 suggests a level closer to 2 percent would be more appropriate. For the simulations presented here, the equilibrium real interest rate in Japan has been set at 2.2 percent and the equilibrium real growth rate has been set at 2 percent. This level for the equilibrium real interest rate is consistent with that used for the United States in Fuhrer and Madigan (1997) and Reifschneider and Williams (1999), although it is above the 1 percent level used in Orphanides and Wieland (1998).

Some Illustrative Simulation Experiments This section presents simple stylized simulations to help develop intuition explaining the results from the stochastic simulations presented in the next section. The simulation experiment consists of a persistent shock to domestic aggregate demand in Japan. We first examine how starting from different baseline solutions that assume different target rates of inflation influences the impact of the ZIF.15 Under an inflation 15In each baseline solution all variables are assumed to be equal to their equilibrium values.

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Table 9.2. Simple Stylized Shock (With inflation target of zero)

Consumption as a percent of potential output

0

1

2

3

70.1

69.5

68.7

68.1

–0.6

–1.4

–2.0

14.4

13.8

13.1

–0.7

–1.3

–2.0

Change since year 0 Investment as a percent of potential output

15.1

Change since year 0 Output gap

0.0

–1.0

–1.9

–2.6

Core inflation

0.0

–0.1

–0.4

–0.9

target of 0 percent, we examine the policy options for stimulating the economy once nominal interest rates have hit the ZIF.

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Calibrating the Stylized Shock The shock that is used in this section of the paper was calibrated to increase in magnitude over the first three years and then to fall over the subsequent five years of the simulation horizon. It consists of negative exogenous impulses to the error terms in the investment and consumption functions.16 Some details from the simulated response to the shock under an inflation target of 0.0 percent and the base-case policy rule are presented in Table 9.2. The shock was calibrated with an eye to the experience in Japan over the late 1990s presented in Table 9.3.17 The declines in investment and consumption relative to potential output are broadly similar to the historical experience. However, the shock unfolds more slowly and the resulting output gap troughs at about 65 percent of the magnitude suggested by the historical data. In the simulation experiments, the policymaker is aware of the current period disturbances hitting the economy, but the policymaker and private agents assume that there will be no additional disturbances in the future. In this sense, the policymaker and private agents are surprised by the shocks that arrive for each of the first eight years of the simulation horizon. The shock-minus-control paths of key macro variables that result from the exogenous disturbances to consumption and investment under 16We do not attempt to identify the structural factors underlying this shock. Several interesting hypotheses that have attempted to account for the weakness in aggregate demand in Japan can be found in Ando (2000), Morck and Nakamura (1999), and Ramaswamy and Rendu (2000). 17These data are from the World Economic Outlook database.

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BEN HUNT AND DOUGLAS LAXTON

Table 9.3. Japan Over the Late 1990s

Consumption as percent of potential output

1997

1998

1999

2000

65.2

63.1

62.6

62.7

–2.1

–2.6

–2.5

14.4

13.6

14.3

–2.1

–2.9

–2.2

Change since 1997 Investment as a share of potential output

16.5

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Change since 1997 Output gap

0.0

–3.4

–4.5

–4.0

Core inflation

0.3

0.3

–0.9

–1.1

the base-case policy rule and four values for the target rate of inflation are presented in Figure 9.1.18 The ZIF becomes binding when the target rate of inflation is 1.0 percent or less. The constraint binds for three, four, and seven years when the inflation targets are 1.0, 0.5, and 0.0 percent. The short-term nominal interest rate troughs at roughly 50 basis points under the 2.0 percent inflation target. The impact of the constraint on real interest rates is striking. Under the 2.0 percent inflation target, the real short-term rate falls by 270 basis points over the first three years. The real rate then remains at that level in the fourth year, after which time it slowly returns toward control. When the ZIF binds, the real interest rate troughs at 250 basis points below control with the 1.0 percent inflation target, 200 basis points with the 0.5 percent inflation target, and 175 basis points with the 0.0 percent inflation target. The higher real interest rates that result when the constraint on nominal interest rates binds mean that real output recovers more slowly from the shock, leading to larger and longer-lived excess supply gaps. After 20 years, the cumulative loss in output is roughly 2.1 percent, 2.2 percent, 2.5 percent, and 3.4 percent under inflation targets from 2.0 to 0.0 percent. The additional excess supply in the economy results in larger declines in inflation and the price level. Under inflation targets of 1.0 and 2.0 percent, the decline in the price level relative to its control path is about 5 percent. However, the price level falls by 7 percent under the 0.5 percent inflation target and by 13 percent when the target rate of inflation is 0.0 percent. These results illustrate, as has other

18To

conduct this experiment we generated four different baseline solutions corresponding to the four different target rates of inflation under consideration: 2.0 percent, 1.0 percent, 0.5 percent, and 0.0 percent. The equilibrium nominal interest rate in each of the baselines will be equal to the equilibrium real interest rate (2.2 percent) plus the target rate of inflation.

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Figure 9.1. Target Rate of Inflation: Deviations from Control Target inflation of 1 percent Target inflation of 0 percent

Target inflation of 2 percent Target inflation of 0.5 percent

Real Bilateral Exchange Rate

Output Gap Percentage points

Percent

2.5

12 8

1.0

4

–0.5

0 –4

–2.0 –3.5

–8 0

2

4

6

8 10 12 14 16 18 20

–12

0

2

Short-Term Nominal Interest Rate Percentage points

1.5 1.0 0.5 0.0 –0.5 –1.0 –1.5 –2.0 –2.5 –3.0 –3.5 -4.0

0

2

4

6

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Percentage points

1.0 0.5 0.0 –0.5 –1.0 –1.5 –2.0 –2.5

6

8 10 12 14 16 18 20

Short-Term Real Interest Rate Percentage points

8 10 12 14 16 18 20

Core Inflation

1.0 0.5 0.0 –0.5 –1.0 –1.5 –2.0 –2.5 –3.0

0

2

4

6

8 10 12 14 16 18 20

Core Price Level

Percent

0

–3 –6 –9 –12 0

2

4

6

8 10 12 14 16 18 20

Government Debt-to-GDP Ratio Percentage points

7 6 5 4 3 2 1 0 –1

4

–15

0

2

4

6

8 10 12 14 16 18 20

Government Expenditure-to-GDP Ratio Percentage points

0.6 0.4 0.2 0.0

0

2

4

6

8 10 12 14 16 18 20

–0.2

0

2

4

6

8 10 12 14 16 18 20

Source: IMF staff estimates.

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BEN HUNT AND DOUGLAS LAXTON

research, that the negative impact of the zero bound increases greatly as the inflation target is lowered toward 0.0 percent. In these simulations, fiscal tax rates are held fixed at their initial equilibrium rates for the first 11 years. Starting in the twelfth year, the aggregate tax rate is allowed to adjust slowly to eventually restore the government’s debt-to-GDP ratio to the values in the baseline.19 As a result of tax rates being held fixed for the first 11 years, the effects on the government-debt-to-GDP ratio increase as the target rate of inflation declines. With lower target rates of inflation, the deterioration in the fiscal position is greater because monetary policy’s ability to reduce real interest rates declines. In the cases where the ZIF is most binding, the government-debt-to-GDP ratio increases significantly because economic activity and the tax base are lower and the higher real interest rates directly increase the servicing costs on the outstanding stock of government-debt.

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One-Off Policy Interventions Using the stylized shock under an inflation target of 0.0 percent, we now turn to consider the effectiveness of policy options designed to stimulate the economy once nominal interest rates have hit the ZIF. The policy interventions occur in the fourth year of the simulation when interest rates have been at the lower bound for a year. Three alternative interventions are considered: an increase in government expenditure; a credible commitment by the monetary authority to unwind the effect on the price level of the deflation; and a sharp depreciation in the currency combined with a credible commitment to a temporary price-level target. The results from these three interventions are presented in Figure 9.2 along with the outcome in the absence of any intervention. The fiscal intervention consists of an increase in government expenditure of roughly 1 percent of GDP for four years. In each of the four years, the fiscal expansion is not expected to last beyond the current year; however, as new negative surprises to aggregate demand arrive, fiscal policy remains loose. Under the first intervention by monetary policy, the policymaker commits in the fourth year to restore all the declines in the price level that have occurred and will occur in the near future owing to the negative shock and the constraint on nominal interest rates. Private agents believe the policymaker will achieve this 19In some cases this convergence process in the government-debt-to-GDP ratio takes longer than 20 years.

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Figure 9.2. One-Off Policy Intervention: Deviations from Control No interventions Fiscal interventions

Svensson interventions Restore price level

Real Bilateral Exchange Rate

Output Gap Percent

Percentage points

4 3 2 1 0 –1 –2 –3

0

2

4

6

8 10 12 14 16 18 20

20 15 10 5 0 –5 –10 –15 –20 –25

0

2

Short-Term Nominal Interest Rate 2 1 0 –1 –2 –3 0

2

4

6

8 10 12 14 16 18 20

–4

0

2

4

Core Inflation 2

10

1

5

8 10 12 14 16 18 20

0

0 Copyright © 2003. International Monetary Fund. All rights reserved.

6

Core Price Level Percent

–5

–1

–10

–2

–15 0

2

4

6

8 10 12 14 16 18 20

Government Debt-to-GDP Ratio Percentage points

7.5 6.0 4.5 3.0 1.5 0.0 –1.5 –3.0 –4.5

8 10 12 14 16 18 20

Short-Term Real Interest Rate

Percentage points

–3

6

Percentage points

Percentage points

4 3 2 1 0 –1 –2 –3

4

–20

0

2

4

6

8 10 12 14 16 18 20

Government Expenditure-to-GDP Ratio Percentage points

1.5 1.0 0.5 0.0

0

2

4

6

8 10 12 14 16 18 20

–0.5

0

2

4

6

8 10 12 14 16 18 20

Source: IMF staff estimates.

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objective and the policymaker does. Under the second monetary policy intervention, the monetary policymaker commits to achieving a price level target that is 5 percent above the price level in the year preceding the commencement of the shock. However, to increase the credibility of such an announcement, the policymaker is assumed to engineer a 15 percent depreciation in the value of the nominal exchange rate (13 percent in the real exchange rate).20 The interventions all prove to be successful. The fiscal intervention eliminates the additional loss in output that arises when the inflation target is zero. After 20 years, the cumulative output loss is 2.2 percent, virtually identical to the cumulative loss of 2.1 percent under the 2.0 percent inflation target. The nominal interest rate becomes positive after four years at zero and the decline in the price level is cut roughly in half. When the policymaker commits to restoring the price level, the cumulative loss in output is reduced marginally from 3.4 to 3.0 percent. Interest rates remain at zero for five years (versus seven years without the intervention) and the decline in the price level is fully reversed. When the exchange rate is depreciated and the medium-term pricelevel target is achieved, the cumulative loss in output is more than recovered as the loss is reduced to 1.6 percent. Interest rates also remain at zero for five rather than seven years. Although each of the strategies helps to mitigate the implications of the non-negativity constraint, there is an interesting difference that arises in the level of government-debt during the period over which tax rates are fixed. In the fiscal intervention case, the government-debt-toGDP ratio has increased 6 percentage points by the tenth year of the simulation—versus a 5 percentage point increase in the absence of an intervention. By contrast, under the monetary policy interventions, the government-debt-to-GDP ratio has declined back to control after 10 years without any change in tax rates. The additional inflation results in lower real interest rates that stimulate aggregate demand. Consequently, tax revenues rise and the cost of servicing the existing stock of government-debt falls. It is interesting that the lower real interest rates and the reduction in the real value of the debt do not arise because inflation surprises private agents. On the contrary, they occur because the 20The simulations assume that the monetary authority can achieve the depreciation that is desired. Svensson (2001) and McCallum (2001) argue that because the monetary authority can print money, it can announce a rate of exchange below the previously prevailing market rate and simply stand ready to sell the quantity of yen demanded at that price. Svensson argues that the value of the exchange rate would have to immediately converge to that rate for any market exchanges to occur. No one would pay a higher price than necessary for yen.

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policymaker successfully convinces private agents that it is going to generate some future inflation. The large difference between the cumulative loss under the Svensson intervention and the other monetary policy intervention arises because of the price level that the policymaker commits to achieving. If the policymaker commits to achieving a price level 5 percent above that when the shock initially hits and does not engineer a depreciation in the exchange rate, then the loss in output is also reduced to roughly the same as that achieved under the Svensson intervention.21 Because of their effectiveness in these simulations at offsetting the negative macroeconomic implications of the ZIF, an important question becomes whether the policymaker can credibly commit to achieving its price-level objective. MULTIMOD’s structure for expected inflation implicitly assumes that a significant proportion of private agents believe the policymaker’s announced target for the price level. However, with nominal short-term interest rates constrained at zero at the time of the announcement, private agents may question the policymaker’s ability to achieve the announced target. Further, the inflation fighting record of the Bank of Japan may also lead private agents to question the policymaker’s commitment to achieve the announced target once the immediate deflationary danger diminishes. MULTIMOD’s structure does not allow for an explicit examination of the types of non–interest rate policy actions considered in Clouse and others (2000), designed to enhance the credibility of the policymaker’s commitment to keep interest rates low in the future. The more confident are private agents that the policymaker will deliver low nominal interest rates in the future, the more credible is the commitment to the future inflation necessary to lower expectations of real interest rates. However, one could interpret the depreciation of the exchange rate in the Svensson intervention as a non–interest rate policy action designed to enhance the credibility of the policymaker’s announced price-level objective. In the simulation presented here, the depreciation does not play an important role; in practice, however, it could be key to generating the required expected inflation.

Stochastic Simulations This section presents summary statistics calculated from artificial data that are generated by performing stochastic simulations on 21For other industrial countries, the difference between these two interventions could be greater because of the larger impact of movements in the prices of imported goods on core inflation.

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MULTIMOD. Under stochastic simulations, the model is perturbed each period by unexpected shocks that directly affect the key behavioral equations in the model. In each period, agents are aware of the disturbances that are currently hitting the economy, but they expected that the values of all disturbances in the future are equal to zero. Stochastic simulations are designed to capture an important dimension of the uncertainty under which policymakers must take decisions: uncertainty about how the future will unfold. A large number of artificial data sets are generated so that statistical inferences can be made about the probability of certain events occurring and how different policy frameworks can alter those probabilities. For the summary statistics presented here, we generate 100 data sets (draws), each of which covers a 100-year period. This provides 10,000 annual observations to use to calculate summary statistics. The standard deviations of the stochastic disturbances that are generally used for this exercise are based on the historical residuals from the associated estimated behavioral equations. However, for the results presented in the first part of this section, the stochastic disturbances are only 80 percent of the magnitude of our best measures of the actual stochastic shocks in our historical database. This reduction in the magnitudes of the shocks was necessary because there were too many solution failures under the zero inflation target with the standard shocks.22 Reducing the magnitudes of the shock terms means that the summary statistics will understate the absolute magnitude of the negative impact that the nominal interest rate constraint will have on economic performance.

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Base-Case Policy Rule Table 9.4 presents some statistics summarizing the simulation results under the base-case policy reaction function. As the inflation target declines from 2.0 percent to 0.0 percent, the probability that the con-

22Theoretical work examining the implications of the zero bound on nominal interest rates, like that present in Uhlig (2000) and Benhabib, Schmitt-Grohé, and Uribe (2002), considers that multiple equilibria are a possibility under the nonlinearity caused by the ZIF. However, the numerical solution technique employed here is only capable of finding solution paths under which the economy converges to a steady state with the policymaker’s specified target rate of inflation without violating the non-negativity constraint. When deflationary spirals become entrenched, the solution algorithm fails because it cannot find such a path given these constraints and those of the model’s structure. As we shall show, an important component of the model’s structure that has a significant impact on the ability to find solution paths satisfying all of the constraints is the monetary policy rule.

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Table 9.4. Base-Case Policy Rule Policymaker’s Target Inflation Rate ___________________________________________________ π* = 2.0 π* = 1.0 π* = 0.5 π* = 0.0 Average deviation of core inflation from target Average output gap

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Percent of time that constraint binds

0.028 –0.03 1

0.024 –0.03 2

–0.002

–0.049

–0.03

–0.04

5

9

Variance of core inflation

0.62

0.62

0.66

0.72

Variance of the output gap

1.31

1.31

1.31

1.31

Percent of draws that failed

0

3

6

24

straint will become binding increases nonlinearly. The impact of the increasing frequency with which the constraint binds shows up in an average deviation of inflation from target that is declining and an average level of the output gap that is also declining. In terms of macroeconomic variability, the increasing frequency of the constraint becoming binding leads to greater variability in core inflation, but not output. Compared to the results in Reifschneider and Williams (1999), the summary statistics presented in Table 9.4 suggest that the constraint is binding less often in Japan than in the United States and the resulting impact on macroeconomic performance is more benign. This is not the case. One factor generating this result is the reduction in the magnitude of the shocks that was required under the base-case policy rule.23 Another important factor is that the summary statistics presented in the table are biased. The statistics presented in Table 9.4 underestimate the true impact of the zero constraint as target inflation declines because we report the summary statistics for all the draws that did not fail under each target

23Reifschneider and Williams (1999) find that deflationary spirals, and thus solutions failures, are more easily avoided under a very similar monetary policy rule for three reasons. First, the macroeconomic model that they use, FRB/US, has more inflation persistence than does the Japan block of MULTIMOD. Second, they incorporate a fiscal policy rule that automatically stimulates the economy if interest rates are constrained at the zero bound for long periods of time. Finally, the authors increase the actual target rates of inflation that appear in the policy rule to compensate for the decline in average inflation outcomes that will otherwise arise in the face of this nonlinearity. For example, to achieve an average outcome of 0.0 percent inflation, the actual target rate for inflation specified in the policy rule is 0.7 percent.

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rate of inflation.24 Even though the magnitudes of the stochastic disturbances are only 80 percent of their estimated historical magnitude, the algorithm was unable to find solutions in 24 of the 100 draws under the 0.0 percent inflation target. This compares with failures in only 6 of the 100 draws for the inflation target of 0.5 percent and 3 out of 100 draws for an inflation target of 1.0 percent. No draws failed under the inflation target of 2.0 percent. Splitting the data from the case where the inflation target is 0.5 percent into two sets can shed some light on how large this bias might be. First, consider the set of draws that did not fail under the 0.0 percent target (76 draws). For this set of draws under the 0.5 percent inflation target, the average deviation of inflation from target is 0.026 and the constraint binds 4 percent of the time. The second set of draws includes those that failed under the 0.0 percent target, but not under the 0.5 percent target (18 draws). In this set of draws under the 0.5 percent inflation target, the average deviation of inflation from target is –0.12 and the constraint binds 9 percent of the time. This illustrates that the 18 draws that failed under the 0.0 percent inflation target but not under the 0.5 percent target are those in which the shocks are pushing the economy more toward deflationary spirals. Clearly, not being able to include these draws in the summary statistics under the 0.0 percent inflation target is biasing the results reported in the table toward underestimating the deleterious implications of the zero bound.

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More Aggressive Monetary Policy Response Replicating the stochastic experiment presented above—but doubling the magnitude of the response coefficients that appear in the monetary policy rule—illustrates how a stronger policy response influences the impact of the non-negativity constraint. In the simulation results from this experiment, there is evidence of two effects of a stronger policy response. If we consider only the 76 draws for which a solution was found under the 0.0 percent inflation target, the first effect is to increase the frequency with which the non-negativity constraint binds from 9 to 13 percent. However, under the stronger policy response there are only 7 rather than 24 draws out of the 100 for which a solution cannot be found. The second effect of the stronger policy response is that it does a better job of avoiding deflationary spirals. 24Looking at only the set of draws that did not fail for all target rates of inflation would also bias the results toward underestimating the impact of the nonnegativity constraint. This occurs because all of the draws that embody the shocks that drive the economy into deflationary spirals under low target rates of inflation are then excluded.

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The qualitative nature of the implications of the ZIF can be inferred from examining the results from the draws that did not fail under the more aggressive policy rule. As can be seen in Table 9.5, the average level of the output gap declines as the inflation target is reduced from 2.0 percent to 0.0 percent, and when the target is 0.0 percent there is significant deviation of core inflation from the target (–0.07 percentage points). The nonlinear impact of the constraint is evident in the change in the frequency with which the constraint becomes binding. As was the case under the base-case rule, the deterioration in macro variability shows up in inflation variability, but not in output variability.

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Committing to Unwinding Declines in the Price Level In a previous section we examined the implications of a one-off policy intervention in which the monetary authority committed to unwinding any declines in the price level that arose because of deflation. Here we consider the implications of incorporating such a commitment systematically into the monetary policy rule. Statistics summarizing the results under the base-case policy rule coefficients with the addition of this price-level commitment are presented in Table 9.6. The first point worth noting is that there is a dramatic reduction in the number of solution failures. Using this policy rule, only a single draw fails under the 0.0 percent inflation target and there were no failures under any of the higher target inflation rates. There are several interesting points to note about the results in Table 9.6. First, even though virtually all of the draws that previously pushed the economy into deflationary spirals under the 0.0 percent inflation target can now be solved, the proportion of the time that the constraint Table 9.5. More Aggressive Policy Response Policymaker’s Target Inflation Rate ____________________________________________________ π* = 2.0 π* = 1.0 π* = 0.5 π* = 0.0 Average deviation of core inflation from target Average output gap Percent of time that constraint binds

0.016 –0.02 2

–0.009

–0.03

–0.07

–0.03

–0.03

–0.04

5

8

14

Variance of core inflation

0.71

0.73

0.76

0.80

Variance of the output gap

1.15

1.15

1.15

1.15

Percent of draws that failed

0

0

2

7

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Table 9.6. Systematically Committing to Unwinding Declines in the Price Level Policymaker’s Target Inflation Rate ____________________________________________________ π* = 2.0 π* = 1.0 π* = 0.5 π* = 0.0 Average deviation of core inflation from target

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Average output gap

0.028 –0.03

0.041 (–0.03)

0.117 –0.02

0.322 –0.01

Percent of time that constraint binds

1

4

7

Variance of core inflation

0.62

0.62

0.58

0.50

Variance of the output gap

1.31

1.34

1.39

1.49

Percent of draws that failed

0

0

0

1

10

binds increases only marginally, from 9 percent to 10 percent. It is lower than the 14 percent achieved under the more aggressive policy rule. Second, the average deviation of inflation from target rises now as the target inflation rate falls. This reflects the behavior of inflation that is required to unwind declines in the price level. Under a 0.0 percent inflation target, all declines in inflation below target must be completely matched with periods of inflation above target. Third, even with this need to generate more inflation in response to deflationary impulses, the variability of inflation actually declines as the target inflation rate falls. Essentially, the price-level commitment on the part of the monetary authority works to constrain the declines in inflation sufficiently to more than offset the additional variability that arises from the need to generate more periods of inflation above target. Fourth, both the average level of the output gap and its variability now rise as the inflation target falls.

Price-Level Targeting Rather than only committing to unwind declines in the price level, the policymaker could commit to a price-level target. Reifschneider and Williams (1999) show that price-level targeting is an effective means of mitigating the implications of the ZIF. Under such a rule, the policymaker commits to achieving a specified target path for the price level. That target path could have a constant growth rate, reflecting a positive rate of underlying inflation, or the path could be a constant with an underlying inflation rate of zero. We replicate the stochastic experiment under a price-level monetary policy rule. The policymaker’s

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target paths for the price level embody the four underlying target rates of inflation considered previously. Under such a rule, the policymaker is striving to set the integral of the deviations of inflation from a target equal to zero. A search over horizons from contemporaneous to five years ahead for this price-level term indicated that that the optimal horizon was contemporaneous. The statistics summarizing the results obtained under price-level targeting are presented in Table 9.7. The price-level rule does help mitigate the implications of the zero bound in the sense that there were fewer solution failures than under inflation targeting. Under the constant-price-level target, 4 draws failed compared with 24 under an inflation target of 0.0 percent. Compared with inflation targeting, the price-level rule delivers lower inflation variability at the cost of greater output variability. The summary statistics in parentheses in Table 9.7 are the results achieved under the policy rule that unwinds all the declines in the price level that occur from periods of deflation. Comparing the summary statistics in parentheses to those achieved under price-level targeting illustrates an interesting point. The asymmetric rule that responds only to restore price level declines does a much better job of combatting the negative implications of the zero floor on nominal interest rates. The case where the target rate of inflation is 0.0 percent and the policyTable 9.7. Price-Level Targeting and Restoring Declines in the Price Level1

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Annual Rate of Change in Price-Level Target (Target Rate of Inflation) ___________________________________________________ π* = 2.0 π* = 1.0 π* = 0.5 π* = 0.0 Average deviation of core inflation from target

–0.012 (0.028)

–0.053 (0.041)

–0.069 (0.117)

–0.083 (0.322)

Average output gap

–0.06 (–0.03)

–0.06 –0.03

–0.07 (–0.02)

–0.08 (–0.01)

Percent of time that constraint binds

1 (1)

5 (4)

8 (7)

14 (10)

Variance of core inflation

0.50 (0.62)

0.54 (0.62)

0.59 (0.58)

0.71 (0.50)

Variance of the output gap

2.22 (1.31)

2.25 (1.34)

2.30 (1.39)

2.40 (1.49)

Percent of draws that failed

0 (0)

0 (0)

1 (0)

4 (1)

1The statistics presented in parentheses are the results when the policymaker commits to unwinding all the declines that occur in the price level from periods of deflation.

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maker unwinds all price level declines is perfectly asymmetric relative to the constant-price-level target case. Under the 0.0 percent inflation target and a commitment to unwind price level declines, the price level is perfectly bounded from below. Under the constant-price-level target, the price level is perfectly bounded from above and below. The first point to note is that the constraint binds a lower portion of the time under the asymmetric rule. It is also worth recalling that because there are slightly more failed draws under the constant-price-level target, the percentage of time that the constraint binds reported in Table 9.7 is biased slightly downward for that rule. Under the 0.0 percent inflation target with the asymmetric-price-level component, the average level of the output gap is higher and the variances of both the output gap and inflation are considerably lower. The number of failed draws is also slightly lower under the asymmetric-price-level commitment, suggesting that it does a slightly better job of avoiding deflationary spirals. Given the fact that the lower bound on nominal interest rates introduces a significant nonlinearity into the monetary control problem, it is not surprising that a nonlinear monetary policy rule is the preferred way to respond. The improvements in the macroeconomic outcomes that result under the asymmetric-price-level commitment arise for two reasons. First, because the policymaker is bounding the price level only from below, policy is not overly concerned with overshooting when generating the required inflation to achieve the price-level objective. Consequently, such a commitment works very effectively to generate expectations of future inflation when required. Second, when the policymaker is bounding the price level from above as well, periods of inflation must be followed by periods of deflation. However, during those periods of required deflation, unexpected negative shocks can more easily drive nominal interest rates down to their lower bound and possibly the economy into deflationary spirals. In macroeconomic models like MULTIMOD, which have a nontrivial forward-looking component in inflation expectations, pricelevel-targeting rules work well because of the implicit credibility that monetary policy enjoys. Consequently, moving from an inflationtargeting rule to a rule with a price-level component may be an effective means of combating the implications of the ZIF. The commitment to generate future inflation is believed by private agents. This raises an important issue regarding how successful such a policy may be in practice. Some might argue that only by committing to a price-level target always and everywhere could a policymaker, through its performance, gain the credibility that it needs. However, as these simulation results suggest, bounding the price level from below and above may entail both

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Table 9.8. Stochastic Disturbances Consistent with Japan’s Historical Experience: Asymmetric Policy Rule Unwinding Price Level Declines Policymaker’s Target Inflation Rate ____________________________________________________ π* = 2.0 π* = 1.0 π* = 0.5 π* = 0.0 Average deviation of core inflation from target Average output gap Percent of time that constraint binds

0.035 –0.04 2

0.071 –0.04 7

0.178

0.397

–0.05

–0.05

12

16

Variance of core inflation

0.98

0.97

0.92

0.90

Variance of the output gap

2.07

2.14

2.25

2.40

Percent of draws that failed

0

3

4

5

greater variability in output and a lower average level of output relative to the case of an asymmetric-price-level target. Consequently, private agents may find the asymmetric-price-level target more credible as it is more consistent with the policymaker’s preferences for output and inflation stability. In addition, both politically and institutionally, the will to generate inflation when required is probably much easier to find than the will to generate deflation.

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Shocks Consistent with Japan’s Historical Experience For the simulation results summarized in Table 9.8, the magnitudes of the stochastic disturbances that hit the economy are not reduced. Using the policy rule that embodies a commitment by the monetary authority to unwind any declines that occur in the price level helps to dramatically reduce the number of solution failures under the 0.0 percent inflation target.25 Compared with the results presented earlier, these results are less biased estimates of how the choice of the target rate of inflation influences the probability that the ZIF will become binding provided that the policymaker is behaving according to a good policy rule.26

25We

examined a policy rule that contained stronger response coefficients and the asymmetric-price-level component. The addition of the stronger response coefficients actually increased the number of solution failures and the proportion of time that the constraint was binding. 26Results achieved under stochastic shocks consistent with historical experience and the symmetric-price-level rule are presented in Hunt and Laxton (2001).

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Even with this policy rule, 5 of the 100 draws could not be solved under the 0.0 percent inflation target. Consequently, these results are still slightly biased toward underestimating the macroeconomic impact of the ZIF. However, one can say that under an inflation target of 0.0 percent and a very good monetary policy rule, the probability that the ZIF will become binding is greater than 16 percent. Even under an inflation target of 1.0 percent, there is at least a 7 percent probability that the constraint will bind. Under a good monetary policy rule, choosing an inflation target of 0.0 rather than 2.0 percent leads to a lower average level of output, higher output variability, and slightly lower inflation variability.

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Conclusions Given the experience in Japan in the late 1990s, Larry Summers’ comments in 1991 have turned out to be prescient. Because nominal interest rates cannot be driven below zero, achieving very low target rates of inflation can impede a monetary authority’s ability to lower real interest rates. The MULTIMOD analysis presented in this chapter suggests that, for Japan, aiming at a target rate of inflation below 2.0 percent may often give rise to persistent periods when monetary policy finds itself unable to reduce real interest rates to the extent desired. In practice, the measurement bias in price indices, the difficulties associated with estimating the level of potential output, and other uncertainties about the monetary transmission mechanism would argue for a target rate of inflation above the 2.0 percent suggested by our stochastic simulation analysis. The analysis illustrates that although there are modifications to systematic monetary policy that can mitigate the impact of this constraint, choosing a sufficiently high target rate of inflation appears to be the most effective way to avoid the problems associated with the lower bound on nominal interest rates. Once nominal interest rates have become constrained by the ZIF, MULTIMOD simulations suggest that there are one-off policy actions that will stimulate aggregate demand and help avoid deflationary spirals. Although both monetary and fiscal policy actions can be effective, either monetary policy intervention or a combination of monetary and fiscal policy action will result in notably less deterioration in the government-debt position. The fundamental point emerging from this work is that there are cures available for the economic malaise that can arise because of the ZIF. However, prevention, in the form of a sufficiently high rate of target inflation, may be the optimal strategy. One might question this pol-

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icy advice if the optimal rate of inflation being prescribed were 10 or 20 percent. However, most research examining the real output costs of inflation finds little or no evidence that an inflation rate as high as 2 or 3 percent entails any significant output sacrifice.27 In fact, in the face of nominal rigidities, there may be benefits associated with low positive rates of inflation if they facilitate the relative price changes that are required for efficient resource allocation.

References Ando, Albert, 2000, “On the Japanese Economy and Japanese National Accounts,” NBER Working Paper No. 8033 (Cambridge, Massachusetts: National Bureau of Economic Research). Benhabib, Jess, Stephanie Schmitt-Grohé, and Martín Uribe, 2002, “Avoiding Liquidity Traps,” Journal of Political Economy, Vol. 110 (June), pp. 535–63. Buiter, Willem H., and Nikolaos Panigirtzoglou, 2000, “Liquidity Traps: How to Avoid Them and How to Escape Them,” Bank of England Working Paper No. 111 (London: Bank of England). Available on the Internet: www. bankofengland.co.uk/workingpapers/wp111.pdf. Clouse, James, Dale Henderson, Athanasios Orphanides, David Small, and Peter Tinsley, 2000, “Monetary Policy When the Nominal Short-Term Interest Rate Is Zero,” Board of Governors of the Federal Reserve System, Finance and Economic Discussion Series, No. 2000-51 (Washington: Federal Reserve Board).

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Fuhrer, Jeffrey C., and Brian F. Madigan, 1997, “Monetary Policy When Interest Rates Are Bounded at Zero,” Review of Economics and Statistics, Vol. 79 (November), pp. 573–85. Hunt, Ben, and Douglas Laxton, 2001, “The Zero Interest Rate Floor (ZIF) and Its Implications for Monetary Policy in Japan,” IMF Working Paper 01/186 (Washington: International Monetary Fund). Isard, Peter, 2000, “The Role of MULTIMOD in the IMF’s Policy Analysis,” IMF Policy Discussion Paper 00/5 (Washington: International Monetary Fund). Khan, Mohsin S., and Abdelhak S. Senhadji, 2001, “Threshold Effects in the Relationship Between Inflation and Growth,” IMF Staff Papers, Vol. 48, No. 1, pp. 1–21. Krugman, Paul R., 1998a, “Japan’s Trap.” Available on the Internet: http://web.mit.edu/krugman/www/japtrap.html. ———, 1998b, “Further Notes on Japan’s Liquidity Trap.” Available on the Internet: http://web.mit.edu/krugman/www/liquid.html. 27Khan and Senhadji (2001) provide some empirical evidence that inflation only has negative effects on growth when it is higher than 1 to 3 percent in industrial countries and higher than 7 to 11 percent in developing countries.

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Laxton, Douglas, Peter Isard, Hamid Faruqee, Eswar Prasad, and Bart Turtelboom, 1998, MULTIMOD Mark III: The Core Dynamic and Steady-State Models, IMF Occasional Paper No. 164 (Washington: International Monetary Fund). Laxton, Douglas, and Eswar Prasad, 2000, “International Spillovers of Macroeconomic Shocks: A Quantitative Exploration,” in EMU, Financial Markets and the World Economy, ed. by Thomas Moser and Bernd Schips (Boston, Massachusetts: Kluwer). ———, 2001, “Possible Effects of European Monetary Union on Switzerland,” Journal of Policy Modeling, Vol. 23 (July), pp. 531–51. Laxton, Douglas, and Robert Tetlow, 1992, “A Simple Multivariate Filter for the Estimation of Potential Output,” Bank of Canada Technical Report No. 59 (Ottawa: Bank of Canada). Lebow, David, 1993, “Monetary Policy at Near Zero Interest Rates,” Board of Governors of the Federal Reserve System, Working Paper/Economic Activity Section, No. 136 (Washington: Federal Reserve System, July). McCallum, Bennett T., 2001, “Inflation Targeting and the Liquidity Trap,” NBER Working Paper No. 8225 (Cambridge, Massachusetts: National Bureau of Economic Research). Meredith, Guy, 1999, “REPMOD: A Smaller Sibling for MULTIMOD,” IMF Working Paper 99/8 (Washington: International Monetary Fund). Morck, Randall, and Masao Nakamura, 1999, “Japanese Corporate Governance and Macroeconomic Problems,” Harvard Institute of Economic Research Discussion Paper No. 1893 (Cambridge, Massachusetts: Harvard Institute of Economic Research).

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Orphanides, Athanasios and Volker Wieland, 1998, “Price Stability and Monetary Policy Effectiveness When Nominal Interest Rates are Bounded at Zero,” Board of Governors of the Federal Reserve System, Finance and Economic Discussion Series, No. 1998-35 (Washington: Federal Reserve System). ———, 2000, “Efficient Monetary Policy Design Near Price Stability,” Journal of the Japanese and International Economies, Vol. 14 (December), pp. 327–65. Ramaswamy, Ramana, and Chrisel Rendu, 2000, “Japan’s Stagnant Nineties: A Vector Autoregression Retrospective,” IMF Staff Papers, Vol. 47 (May) pp. 259–77. Reifschneider, David L., and John C. Williams, 1999, “Three Lessons for Monetary Policy in a Low Inflation Era,” Journal of Money, Credit and Banking, Vol. 32 (November), pp. 936–78. Summers, Lawrence H., 1991, “Price Stability: How Should Long-Term Monetary Policy Be Determined?” Journal of Money, Credit and Banking, Vol. 23 (August) pp. 625–31. Svensson, Lars E.O., 2001, “The Zero Bound in an Open Economy: A Foolproof Way of Escaping From a Liquidity Trap,” Monetary and Economic Studies, Vol. 19 (February), pp. 277–312.

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Taylor, John B., 1993, “Discretion Versus Policy Rules in Practice,” CarnegieRochester Conference Series on Public Policy, Vol. 39 (December), pp. 195–214.

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Uhlig, Harald, 2000, “Should We Be Afraid of Friedman’s Rule?” Journal of the Japanese and International Economies, Vol. 14 (December), pp. 261–303

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10 Monetary Policy in a Deflationary Environment TAIMUR BAIG

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J

apan’s lengthy economic stagnation and persistent deflation continue to generate lively discussions in academia and policy circles. To the extent that price developments are considered a monetary phenomenon, a significant portion of the literature deals with monetary policy–related issues, especially how to combat deflation. What are the channels of transmission that would allow further easing to permeate through the economy even when short-term interest rates have reached their floor? The issue is further complicated by the existence of significant banking sector problems in Japan. With the Bank of Japan embarking on a quantitative easing framework since March 2001, discussions on the instruments and capacity to carry out monetary easing under zero short-term interest rates have taken center stage. Despite a series of easing measures, which have led to sizable increases in base money, deflation continues, leading to the question of whether monetary policy has essentially run its course in Japan. However, the answer is not straightforward. A careful examination of the various channels of transmission and the associated lag structure is needed to evaluate the ability of monetary policy to influence demand and prices in Japan. Also, a historical comparison with previous deflationary episodes can provide useful clues on the extent of easing necessary to restore positive price growth. The goal of this chapter is to explore monetary policy’s role in combating deflation in Japan, both from a comparative and empirical perspective. On the comparative side, the chapter examines deflationary 206

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episodes from Sweden and the United States in the 1930s. On the empirical side, the chapter uses reduced-form vector autoregressions (VARs) to analyze Japan’s monetary transmission mechanism. This approach allows one to impose minimal restrictions on how monetary shocks influence the economy, while recognizing the simultaneity between monetary impulses and macro variables. A simple monetary model is first estimated, and is then augmented by incorporating a banking sector indicator. Subsequently, the exchange rate and asset price channels are examined to see if monetary easing can potentially have a positive impact on activity and prices through these channels. The analysis suggests that in the Swedish and the U.S. cases in the 1930s, the extent of monetary expansion that was necessary to restore positive price growth was larger than the magnitude of base money growth seen in Japan so far. The empirical analysis indicates a potentially favorable impact of quantitative easing, through the asset price or portfolio rebalancing channel. The results show that banking sector weaknesses do not completely short-circuit the transmission between increases in base money and other macroeconomic variables, but they do indicate that addressing such problems would increase the effectiveness of monetary policy.

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Monetary Policy to Combat Deflation: Some Earlier Episodes The worldwide economic collapse of the 1930s provides several case studies of monetary policy operation in a deflationary environment. In this section, the Swedish and the U.S. experiences are examined. Episode 1: Sweden in the 1930s In the fall of 1931, the Swedish central bank (Riksbank) announced a price stability target.1 Owing to the experience from the country’s previous deflationary episode, the Swedish authorities were keenly aware of the potential cost of failing to fight a sustained fall in prices. In the early 1920s, the Riksbank’s refusal to lower interest rates at a time when prices were falling by 20 percent (year-on-year) led to an economic plunge, with Swedish GDP falling by 35 percent between 1920 and 1922. Thus, as the worldwide depression and deflationary pressures forced Sweden to search for an alternative to the gold standard, the Riksbank 1The

discussion on Sweden draws primarily on Berg and Jonung (1999).

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was mandated to combat deflation vigorously with full instrument independence.2 Although no specific target level was spelled out, the program clearly stated the desirability of having the price level recover. Indeed, in September 1931, the Swedish minister of finance instructed the Riksbank to take necessary actions to maintain the domestic purchasing power of the krona. The Riksbank focused on reviving expectations of underlying inflation—that is, excluding temporary taxes, customs duties, and seasonal effects. A weekly consumer price index allowed policymakers to monitor the impact of monetary policy. In pursuing its mandate, the Riksbank reduced the discount rate by 350 basis points to 2.5 percent between 1932 and 1934 and maintained it at this level until 1939; it also carried out unsterilized interventions in the foreign exchange market. In addition, the krona exchange rate was effectively devalued and then pegged to the British pound from 1933 onward. Buoyed by these easing measures, base money expanded by 92 percent between 1931 and 1936. Prices did not react immediately to the monetary easing, with inflation turning positive only in 1934, nearly three years after the beginning of the program (see Figure 10.1, top panel). However, with the monetary program combined with a series of measures to boost the real economy and address some problems in the financial sector, Sweden was able to come out of economic stagnation by the mid-1930s. The Swedish case provides two important lessons. First, an explicit commitment to end deflation can be useful to raise inflation expectations when there are widespread fears of deflation in the economy. Second, the central bank has to be prepared to ease substantially, and do so for a long period of time, to achieve its goals. Episode 2: U.S. Recovery from the Great Depression The United States departed from the gold standard in 1933, which subsequently paved the way for a massive monetary expansion on a scale unprecedented in the country’s economic history. Although it is beyond the scope of this paper to discuss the extensive literature investigating the causes of the Great Depression, Friedman and Schwartz (1963) and Bernanke (1983, 1995) suggest that monetary contraction was the principle underlying factor. What brought the United States back from a vicious deflationary spiral? Beginning in 1933, very low interest rates (the discount rate was 2The

instrument independence of the Riksbank was explicitly mandated in 1933.

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Figure 10.1. Base Money Growth and Inflation (Percent) CPI inflation

Base money growth

35 30

Sweden: 1930–36

25 20 15 10 5 0 –5 –10

1930

31

32

33

34

35

36

1932

1933

1934

1935

1936

35 30

United States: 1930–36

25 20 15 10 5 0 –5

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–10

1930

1931

35 30

Japan: 1998–20011

25 20 15 10 5 0 –5 –10

1998

1999

2000

2001

Sources: Bank of Japan; Central Bank of Sweden; U.S. Bureau of Labor Statistics; and Bernanke (1995). 1End-September data.

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kept at or below 2 percent for the rest of the decade) and leaving gold inflows unsterilized boosted base money by 60 percent in three years (Figure 10.1, middle panel). With this, CPI inflation went from –5 percent in 1933 to averaging over 2 percent in the following three years. Romer (1992) argues that the monetary expansion was key to the dramatic recovery of U.S. output and prices in the 1930s. She shows that a substantial decline in ex ante real interest rates (driven by rising inflation expectations) coincided with the beginning of the monetary expansion, which supports the existence of a conventional interest rate mechanism in passing on the effects of monetary easing. Along similar lines, Bernanke (1995) stresses that reflation was a leading component of the U.S. economic revival, although he also points out that the New Deal’s rehabilitation of the financial system was a prerequisite for the recovery. Some researchers have argued that it was not the U.S. Federal Reserve’s stance, but rather the decision of the Roosevelt administration to leave surging gold inflows unsterilized that was instrumental in the monetary expansion. However, even without deciding which actor was instrumental, there is general support in the literature that in the U.S., a deflationary regime was replaced by a very expansionary monetary policy from 1933 onward.3

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The Japanese Context Prices in Japan have fallen each year since 1999. In its efforts to combat deflation, the Bank of Japan introduced a quantitative easing framework in March 2001. Under this framework, the Bank of Japan pushed the overnight call rate close to zero by targeting current account balances (bank and non-bank reserves) held at the central bank. The target was tripled during the course of 2001, and balances were at the upper end of the ¥15–20 trillion target at end-2002. At the same time, the Bank of Japan steadily increased its monthly outright purchase target of Japanese government bonds (JGBs), from ¥400 billion in March 2001 to ¥1.2 trillion in October 2002.4 These actions have resulted in rapid base money growth—27 percent (year-on-year) in June 2002— but that peaked in March 2002. Meanwhile, bank lending has contin-

3See

Romer (1992) and Temin and Wigmore (1990). note that even prior to targeting the current account balances, the Bank of Japan kept the policy interest rate at or near its floor throughout the late 1990s and early 2000s. 4Also,

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Figure 10.2. Inflation, Interest Rates, and Money, 1995–2002 (Percent a year) 3.0 2.5 2.0 1.5 1.0 Overnight call rate

0.5 0 –0.5 –1.0

CPI Inflation

–1.5 –2.0

1995

96

97

98

99

2000

01

02

40 35 30 25 20 15 Base money

10

M2 + CDs

5 0

Bank lending

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–5 –10

1995

96

97

98

99

2000

01

02

Sources: DRI-WEFA, Nomura Database.

ued to decline, broad money growth remains stagnant at 3–4 percent, and deflationary pressures have shown little signs of abating. Recent increases in base money growth notwithstanding, monetary expansion has not reached the levels seen in the historical episodes discussed above (Figure 10.2, bottom panel).5 In fact, base money grew by a cumulative 42 percent over the three and a half years since 1999, 5See Fujiki, Okina, and Shiratsuka (2001); and Fujiki and Shiratsuka (2002), for detailed expositions on the operational aspects of Japanese monetary policy in the late 1990s. Shirakawa (2002) examines the impact of base money growth in the last year.

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clearly falling short of the expansion seen in Sweden or the United States in the 1930s. It is nevertheless hard to draw direct parallels between the historical episodes discussed above and the situation in Japan today. Clearly, deflationary pressures were more severe in the Swedish and U.S. cases than in Japan today.6 However, the two episodes suggest that combating deflation requires decisive, substantial, and sustained monetary policy efforts.7 Moreover, when compared with the Swedish monetary program, which gave the central bank instrument independence to back up a strongly worded mandate to resist deflation, the Bank of Japan’s stance simply indicates its intent to maintain the present policy framework until deflation ends. Thus, in the Japanese context, has the Bank of Japan exhausted its means already, or can it feasibly combat deflation more vigorously? While base money growth rates in recent years fall short of the levels seen in the historical episodes, the issue warrants further examination, especially by taking into account the role of banks and asset markets. In the following sections, we address this issue empirically. We begin with an overview of the possible sources of monetary policy transmission under the zero-rate bound.

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Transmission Channels at the Zero-Rate Bound The Japanese case departs from the historical episodes discussed above in one striking way—short-term nominal interest rates are already at their floor.8 This section focuses on possible channels of transmission when the policy rate has reached its floor. They are as follows. • Expectations channel. Easier monetary policy, if credible, increases inflationary expectations in the economy, which then leads to higher wage increases and upward price pressures. Rising inflationary expectations also lower real interest rates, providing further impulse to consumption and investment. 6However,

studies dealing with the quality of Japan’s price statistics have raised concerns that deflation may be substantially worse than reported in the official data. In a recent paper, Ariga and Matsui (forthcoming) argue that CPI deflation could be worse by as much as 1 percent a year. The factors responsible for this include upward bias owing to infrequent rebasing, lack of coverage of discount stores, and not properly incorporating the effects of products’ quality changes. 7Svensson (1999, 2001) argues that transparent inflation or price level targeting, along with coordinated fiscal and monetary expansion, can contribute to escaping a liquidity trap. 8Under the conventional interest rate channel, lowering the rate reduces the cost of capital, which then increases the interest-sensitive components of aggregate demand, as

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• Credit channel. Expansionary impulses of monetary policy are transmitted through increases in bank lending. Even when interest rates are zero, monetary expansion reduces the external finance premium as liquidity improves and asset prices rise. The cost of borrowing falls, leading to an increase in lending. • Exchange rate channel. A monetary loosening depreciates the exchange rate, which, given nominal rigidities, translates into a short-run depreciation of the real exchange rate, boosting net exports. • Asset price or portfolio rebalancing channel. A monetary expansion, through say the purchase of bonds, reduces the yield on such assets (that is, long-term bond yields), causing the public to rebalance its portfolio, and leads to changes in the prices of a wide range of assets, affecting wealth, consumption, and investment. A number of recent papers on Japan have suggested that monetary expansion, even under zero rates, can generate price expectations through the channels discussed above. Statistical analysis by Meltzer (1999, 2000) suggests that a failure to allow the exchange rate to depreciate has been instrumental in the latest output decline and deflation episode, and that a more expansive monetary policy is essential to revive demand and end deflation. Meltzer recommends that, given the lower bound on interest rates, the Bank of Japan should pursue an adaptive rule for growth of the monetary base (the rule would respond to lower output growth and accommodate any increases in money demand). He also recognizes that a possible consequence of the expansionary policy is depreciation of the yen. Goodfriend (2001), stressing the importance of monetary policy over fiscal policy in deflationary episodes, argues in favor of quantitative monetary easing stimulating the economy through the portfolio rebalancing effect. He also argues that aggressive open market operations can reduce external finance premiums even when short-term interest rates are at the zero bound. Bernanke (2000) argues that it is not low nominal interest rates but, rather, the extent of monetary expansion that adequately signals the

well as boosting price expectations. However, in an interesting exposition, Nelson (2002) shows that even after controlling for the short-term interest rate, base money growth is a significant determinant of total output (relative to potential) in both the United States and the United Kingdom. He explains this by arguing that money growth contains information about the term structure not captured by short- or long-term market interest rates. Base money growth, therefore, is a useful predictor of aggregate demand above and beyond interest rates.

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monetary policy stance. Monetary easing is bound to have an impact on the economy as the price level cannot be completely independent of money issuance.9 Thus, one should expect sustained monetary easing to revive price expectations. In the Japanese context, Bernanke argues that the credibility of the commitment to eliminate deflation could be made more concrete by adopting the guiding principles of an inflation target. Do the Japanese data support the existence of the channels discussed above? In the next section, a monetary model of Japan is empirically tested, examining whether base money expansion can have the desired effect on activity and prices after controlling for the fact that shortterm interest rates are already zero.

A VAR Exploration of Japan’s Monetary Transmission Mechanism

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Methodology and Data The first step is to estimate a basic monetary model, featuring output demand, prices, interest rates, and money, with quarterly, seasonally adjusted data from 1980 to 2001 (see the Appendix for data sources). The methodology followed is along the lines of Morsink and Bayoumi (2000). Output demand is measured as real private demand (derived by subtracting total government spending from real GDP) relative to potential output. The uncollateralized overnight call rate is used for the interest rate variable. Prices are measured by the log of the CPI, and the monetary variables are expressed as a ratio of potential output. Thus, when looking at the numbers, a 0.1 change represents a 1 percent change in the relevant variable. The VAR is identified by using the standard Choleski decomposition, with the order being prices, private demand, interest rates, and money.10 The choice of ordering was based on the speed with which the variables respond to shocks—that is, prices are assumed to respond last, and the monetary variable is assumed to be the most responsive. The VARs include two lags of each variable. In addition to the endogenous variables listed above, the VAR also includes the following exogenous variables: a constant term, a time trend, and three dummy variables. The first two dummies are aimed at capturing short-term demand shifts owing to the introduction of the consumption tax in April 1989 and its increase in April 1997. The 9If that were the case, monetary authorities could create money to purchase indefinite quantities of goods and assets without affecting prices. 10The ordering determines the level of exogeneity of the variables.

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third dummy aims to control for a Y2K-related temporary surge in liquidity demand during the final quarter of 1999. The basic VAR is extended by incorporating the role of banks. Bank loans are used to model shocks to bank assets (expressed also as a share of potential GDP). Loans are considered to adjust faster than output, but slower than the rest of the variables in the model. To allow examination of the exchange rate and asset price channels, subsequent extensions of the model include the nominal effective exchange rate and a stock price index (TOPIX), both expressed in logs. These variables are assumed to adjust more quickly, immediately after a monetary shock.

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Basic Model As a first step, a basic model is estimated to confirm that the data generate standard results found in the monetary policy transmission literature. The results, illustrated through the impulse response functions summarized in Figure 10.3 (top panels), indicate that broad money shocks have a significant impact on output (with the shock dying out after about 12 quarters). The finding that a broad money shock has a significant impact on demand, even with the interest rate included in the VAR as a separate variable, implies that there are other channels beyond the interest rate channel through which the monetary transmission process takes place. The implied one-year elasticity of output with respect to broad money is 0.05—that is, a 1 percent increase in broad money raises private demand by less than 0.1 percent.11 Prices respond significantly to an output shock, with a one-year elasticity of 0.2. Prices also respond to innovations in broad money, but the response becomes significant 2!/2 years after the shock. The implied multiplier of prices with respect to broad money is 0.07. Thus monetary shocks impact prices and demand, while prices also get impacted by demand shocks. Any explanation of the monetary transmission mechanism in Japan must take into consideration the fact that with short-term interest rates at their floor, base money has become the Bank of Japan’s primary monetary policy instrument. Base money is therefore incorporated in the above model. Adding base money to the model (ordering it last) and rerunning the VAR, it is found that in the one year subsequent to a base money shock, prices respond with an elasticity of around 0.04, implying that a 23 percent base money shock would raise the CPI by 1 percent. 11To derive the elasticities, the statistically significant responses of the relevant variable over the specified period are first summed, and then divided by the standard deviation of the variable that is the source of the shock.

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Also, after adding base money, output’s response to a broad money shock, and the response of prices to broad money and output shocks, remain virtually unchanged and their respective statistical significance is undiminished (Figure 10.3, top panels). The small magnitude of the elasticity estimate suggests that substantial easing is required to generate an upward trend in prices, and the rather lengthy lag structure seen in the impact of prices on broad money suggests that the monetary authorities may have to wait for quite some time before seeing prices recover. Statistically, the impulse response from base money to prices is found to be insignificant. Given that the model estimated in this section does not take into account a number of pertinent factors relevant to Japan—for example, bank loans and asset prices—this is not surprising. In the subsequent subsections, the monetary model is augmented to incorporate a richer range of interactions in the transmission mechanism.

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Incorporating the Banking Sector Weaknesses in the banking sector are likely to impact the monetary transmission. Morsink and Bayoumi (2000) show that bank loans are an important component in the monetary transmission process in Japan. Following their methodology, a bank loans variable is incorporated in the basic model and the VAR impulse response functions (Figure 10.3, middle panels) are examined. The CPI responds positively to innovations in private demand, bank loans, and money shocks (both broad money and base money). With the exception of prices to demand, the results once again hint at a substantial lag structure, with the responses becoming statistically significant only in the fourth year subsequent to the shocks. Focusing on the CPI response to base money innovations, the one-year elasticity is about 0.05—that is, a 20 percent base money shock would raise the CPI by 1 percent, comparable to the findings in the basic monetary model, although the standard error associated with the impulse estimate is substantially improved (it is significant around the 10 percent level). The role of bank loans in the transmission mechanism is further examined by exogenizing bank loans in the calculation of the impulse responses.12 Exogenizing bank loans substantially reduces the impulse 12This is done by rerunning the VAR, with the lagged values of bank loans treated as exogenous variables in a smaller VAR involving private demand, prices, interest rate, and money. This procedure allows us to reestimate the banking model, except that this time any responses within the VAR that pass through the bank loans variable are blocked off. Comparing the results of these two VARs provides a measure of the importance of bank loans in the monetary transmission mechanism.

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Figure 10.3. Selected Impulse Responses from the Basic Model

(Response of 1 Cholesky standard deviation innovation ± 2 standard errors) 0.005

0.008 CPI to Broad Money

0.004

0.006

Real Private Demand to Broad Money

0.003 0.002

0.004

0.001

0.002

0 0

–000.1 –000.2

1

3

5

7

9

11

13

15

–0.002

1

3

5

Quarters

9

11

13

15

11

13

15

13

15

0.003

0.006 CPI to Broad Money 0.004

7

Quarters CPI to Base Money

(with base money incorporated in model)

0.002 0.001 0

0.002

–0.001 0 –0.002 –0.002

1

3

5

7

9

11

13

15

–0.003

1

3

5

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Quarters 0.006

7

9

Quarters 0.003

Real Private Demand to Bank Loans

CPI to Base Money (incorporating bank loans

0.002 in the model)

0.004

0.001 0.002 0 0

–0.002

–0.001

1

3

5

7

9

Quarters

11

13

15

–0.002

1

3

5

7

9

Quarters

Source: IMF staff estimates.

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response of private demand to broad money, which indicates that bank loans play an important role in the transmission of shocks from money to output (Figure 10.3, bottom panels). One way of looking at this result is that to fully leverage the effectiveness of monetary policy, the banking sector must be strengthened. The results from this section underscore two points. First, they reinforce the conclusion of Morsink and Bayoumi with respect to the importance of the banking sector in the monetary transmission mechanism. Second, even when the banking sector activities are incorporated in the model, a statistically significant impulse of money to demand is found. This indicates that monetary transmission mechanism is not completely short-circuited by banking sector weaknesses. Also, the results show that prices can be influenced by base money injection after controlling for the above factors.

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Equity Price and Exchange Rate Channels So far, the specifications have not taken into account the impact of monetary easing on asset prices. Consequently, equity prices (the broad Japanese stock market index, TOPIX) and the nominal effective exchange rate (NEER) are added to the model. The first result of interest in the model with equity prices is that consumer prices react positively and significantly to innovations in base money. Prices respond to private demand with a one-year elasticity of 0.2 and four-year elasticity of 0.9, comparable to the findings in the previous sections. The implied one-year elasticity of prices with respect to base money shock is 0.04, close to the results found in the previous sections (to push up the CPI by 1 percent in a four-quarter horizon, base money would have to be boosted in excess of 25 percent). The result is statistically significant. (Figure 10.4). The results thus indicate that base money expansion can positively influence consumer prices within a year. Stock prices react positively to monetary shocks, which in turn stimulate demand and banking activities, and finally prices.13 The price multiplier is rather small (but the impulse response is statistically significant at the 10 percent level), as seen also in the previous sections, indicating that a substantial base money injection is required to have a significant impact on the prices.

13Innovations in TOPIX positively impact loans, with a one-year elasticity of 0.2 and four-year elasticity of 2.0. Moreover, private demand reacts positively to innovations in loans and stock prices. The elasticity of demand with respect to stock prices is 0.1. The impulse response remains statistically significant throughout the 16-quarter window.

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Figure 10.4. Role of Bank Loans (Response to one standard deviation innovation) 0.0025

Response of Output to Broad Money (Banking sector model)

0.0020

Bank loans endogenized

0.0015 Bank loans exogenized

0.0010

0.0005

0

1

2

3

4

5

6

7

8

9

10

11

12

Quarters

Copyright © 2003. International Monetary Fund. All rights reserved.

Source: IMF staff estimates.

Given that short-term rates have been at their floor recently, it is interesting to examine if the results break down when controlled for the interest rate channel. This is done by rerunning the above VAR with the interest rate exogenized. The impulse response of price to innovations in base money weakens somewhat as a result, but only in the long run. During the first year following a shock, when the response is statistically significant, the magnitude of the impulse responses are found to be comparable between the two VARs (Figure 10.5). The finding once again supports the premise that policy efficacy is not entirely negated even at zero interest rates. Finally, stock price is replaced with NEER (Figure 10.6).14 The statistical relationship between base money and NEER is found to be insignificant, probably on account of relatively large swings in the exchange rate during the sample period. Private demand reacts positively to a NEER depreciation, with an elasticity of –0.01, but the statistical significance of the reaction is diminished after only one quarter.

14With respect to the exchange rate, an increase in the variable’s value implies an appreciation, and vice versa. Note that the results obtained in this section remain virtually unchanged when the NEER variable is replaced with the yen-dollar exchange rate.

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Figure 10.5. Monetary Model with Stock Prices

(Response of 1 Cholesky standard deviation innovation ± 2 standard errors) 0.006

0.004

CPI to Real Private Demand

0.005

CPI to Base Money

0.004 0.002

0.003 0.002 0.001

0

0 –0.001 –0.002

1

3

5

7

9

11

13

15

–0.002

1

3

5

Quarters 0.008

Real Private Demand to TOPIX

0.16 0.12

0.004

0.08

0.002

0.04

0

0

1

3

5

7

9

Quarters

11

9

11

13

15

13

15

Quarters

0.006

–0.002

7

13

15

–0.04

Bank Loans to TOPIX

1

3

5

7

9

11

Quarters

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Source: IMF staff estimates.

Prices, on the other hand, react significantly to an exchange rate shock over the first four quarters, with the CPI rising by 0.05 percent in response to a 1 percent depreciation of the NEER. Following the approach in the bank loan scenario, when NEER is exogenized, the impulse from broad money to demand is weakened somewhat, suggesting that the exchange rate channel plays a role in the transmission process.

Conclusion This chapter has explored the role of monetary policy in combating deflation in Japan. A number of tentative conclusions can be drawn from the historical episodes discussed and the empirical analysis of Japan.

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Figure 10.6. Role of Interest Rates (Response to one standard deviation of innovations) 0.0010 Response of CPI to Broad Money

0.0008

(Stock market model)

0.0006

Interest rate endogenized

0.0004 0.0002 Interest rate exogenized

0 –0.0002

1

2

3

4

5

6

7

8

9

10

11

12

Quarters

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Source: IMF staff estimates.

• To combat deflation in the 1930s, the authorities in Sweden and the United States allowed for substantial easing that lasted for several years. These episodes also illustrate the importance of pushing for reforms in the real and financial sectors, which in turn smoothes the channels of monetary policy transmission. • The empirical analysis suggests that despite short-term interest rates being at their floor, additional base money injection could have a positive impact on prices and activity. Base money injection can be effective through the portfolio rebalancing channels. The strongest result from the VAR exercise is obtained when the respective roles of the stock market and bank loans are combined with the variables of a standard monetary model. • The chapter’s findings support the notion that, when prices are falling, monetary easing has to be substantial and sustained for an extended period to stimulate demand and increase price expectations. • Incorporating the banking sector in the monetary model shows the importance of banks in the monetary transmission process, underscoring the critical need to resolve banking weaknesses. While banking sector reform is of great importance, the results indicate that the existence of weaknesses in the sector does not completely shut out the channels of monetary transmission.

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Appendix: Data Sources • Demand: Economic Planning Agency, Annual Report on National Accounts. • Consumer Price Index, interest rate, monetary aggregates, bank loans: Bank of Japan, Economic Statistics Monthly. • Exchange Rate, Stock Market Index (TOPIX): Bloomberg. • Swedish historical prices: Swedish Central Bank, http://www.scb.se/eng/ index.asp • U.S. historical prices: Bureau of Labor Statistics, http://www.bls.gov/cpi/ • Swedish and U.S. historical monetary data: Bernanke (1995).

References Ariga, Kenn, and Kenji Matsui, forthcoming, “Mismeasurement of CPI,” in Structural Impediments to Growth in Japan, ed. by Magnus Blomström, Jennifer Corbett, Fumio Hayashi, and Anil Kashyap (Chicago: University of Chicago Press). Available on the Internet: http://www.nber.org/books/growth-japan/ ariga-matsui5–30–02.pdf. Berg, Claes and Lars Jonung, 1999, “Pioneering Price Level Targeting: The Swedish Experience 1931–1937,” Journal of Monetary Economics, Vol. 43 (June), pp. 525–51. Bernanke, Ben S., 1983, “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression,” American Economic Review, Vol. 73 (June), pp. 257–76.

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———, 1995, “The Macroeconomics of the Great Depression: A Comparative Approach,” Journal of Money, Credit and Banking, Vol. 27 (February), pp. 1–28. ———, 2000, “Japanese Monetary Policy: A Case of Self-Induced Paralysis?” Japan’s Financial Crisis and Its Parallels to the U.S. Experience, ed. by Ryoichi Mikitani and Adam A. Posen, IIE Special Report No. 13 (Washington: Institute for International Economics), pp. 149–66. Friedman, Milton, and Anna J. Schwartz, 1963, A Monetary History of the United States, 1867–1960 (Princeton, New Jersey: Princeton University Press). Fujiki, Hiroshi, Kunio Okina, and Shigenori Shiratsuka, 2001, “Monetary Policy Under Zero Interest Rate: Viewpoints of Central Bank Economists,” Monetary and Economic Studies, Vol. 19 (February), pp. 89–129. Fujiki, Hiroshi, and Shigenori Shiratsuka, 2002, “Policy Duration Effect under the Zero Interest Rate Policy in 1999–2000: Evidence from Japan’s Money Market Data,” Monetary and Economic Studies, Vol. 20 (January), pp. 1–32. Goodfriend, Marvin, 2001, “Financial Stability, Deflation, and Monetary Policy,” Monetary and Economic Studies, Vol. 19 (September), pp. 143–67. Meltzer, Alan H., 1999, “The Transmission Process” (unpublished; Carnegie Mellon University).

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———, 2000, “Monetary Transmission at Low Inflation: Some Clues from Japan in the 1990s,” Institute for Monetary and Economic Studies Discussion Paper No. 2000–E–25 (Tokyo: Bank of Japan). Morsink, James, and Tamim Bayoumi, 2000, “Monetary Policy Transmission in Japan,” Post-Bubble Blues: How Japan Responded to Asset Price Collapse, ed. by Tamim Bayoumi and Charles Collyns (Washington: International Monetary Fund), pp. 143–63. Nelson, Edward, 2002, “Direct Effects of Base Money on Aggregate Demand: Theory and Evidence,” Journal of Monetary Economics, Vol. 49 (May), pp. 687–708. Romer, Christina D., 1992, “What Ended the Great Depression?” Journal of Economic History, Vol. 52 (December), pp. 757–84. Shirakawa, Masaaki, 2002, “One Year Under ‘Quantitative Easing’,” Institute for Monetary and Economic Studies Discussion Paper No. 2002–E–3 (Tokyo: Bank of Japan). Svensson, Lars E.O., 1999, “How Should Monetary Policy Be Conducted in an Era of Price Stability?” CEPR Discussion Paper No. 2342 (London: Center for Economic Policy Research). ———, 2001, “The Zero Bound in an Open Economy: A Foolproof Way of Escaping From a Liquidity Trap,” Monetary and Economic Studies, Vol. 19 (February), pp. 277–312.

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Temin, Peter, and Barrie Wigmore, 1990, “The End of One Big Deflation,” Explorations in Economic History, Vol. 27 (October), pp. 483–502.

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11 The Yen-Dollar Rate: Have Interventions Mattered? RAMANA RAMASWAMY AND HOSSEIN SAMIEI

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T

he yen-dollar rate has been more than just the exchange value of one currency against another. Fluctuations in the yen-dollar rate in the 1980s, for instance, became enmeshed in an outbreak of trade frictions between Japan and the United States. Swings in the yen-dollar rate have also had systemic effects on the global economy. The sustained depreciation of the yen against the dollar, beginning in mid1995, eroded the external competitiveness of a number of Asian countries that had pegged their currencies closely to the dollar, and became one of the triggers for the Asian crisis in 1997. More recently, the abrupt appreciation of the yen has threatened to scupper Japan’s fragile recovery from its worst postwar recession. It is therefore not much of a surprise to find that policymakers in Japan have intervened repeatedly in foreign exchange markets to influence the yen-dollar rate, and that markets have avidly monitored every one of these moves. The critical question, however, is whether these interventions have made a difference to the yen-dollar rate. Perceptions about the effectiveness of foreign exchange interventions have changed over time. The coordinated interventions that followed the Plaza Accord in September 1985 were followed by a sustained decline in the exchange value of the dollar against the yen; econometric studies indicate that these interventions had a statistically significant impact on exchange rates.1 The weakening dollar was, how-

1Dominguez and Frankel (1993), for instance, use an augmented portfolio balance model, incorporating exchange rate expectations, to show that interventions had a sta-

224

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 225

ever, not initially accompanied by a reduction in current account imbalances between Japan and the United States, and it accentuated trade frictions. This outcome also had the effect initially of generating skepticism about the effectiveness of interventions, even though the success of interventions ought to be measured strictly by their impact on the exchange rate, and not by how the subsequent adjustment process works. However, as noted by Krugman (1991) in a review of developments during this period, the external imbalances between Japan and the United States did subsequently narrow significantly between 1988–90, with the lag being due to “J-curve” effects.2 Despite the post–Plaza Accord experience, doubts about the effectiveness of foreign exchange interventions have lingered, and have come to the fore again as the exchange value of the yen has oscillated since the mid-1990s. Despite a series of interventions conducted by the Bank of Japan to weaken the yen during early 1995, it continued to appreciate, reaching a high of about ¥80/$ in April 1995 (Figure 11.1). As dollar-buying operations continued throughout that year, including episodes of coordinated interventions and an easing of monetary policy in Japan, the yen depreciated significantly, crossing the ¥125/$ mark in early 1997. The Japanese authorities soon after had to change strategy, and began instead to intervene to prevent the exchange value of the yen from depreciating further. However, with confidence in the yen dented by the advent of the Asian crisis in July 1997 and the financial panic generated by the bank failures in Japan in late 1997, the yen continued to depreciate, reaching ¥145/$ by August 1998. The turbulence in global financial markets intensified at that point, resulting in an abrupt unwinding of the so-called “yen-carry-trades,” and the yen began to appreciate dramatically, reaching ¥110/$ by January 1999. Surrealistically, the Japanese authorities were forced within the span of a few months to shift from a strategy of intervening to strengthen the yen to one of intervening once more to weaken the yen. As economic conditions in Japan deteriorated, the yen depreciated against the dollar

tistically significant impact on exchange rates in the post–Plaza Accord period; interventions are also shown to have mattered during 1982–84, when skepticism about the effectiveness of interventions was pervasive. See, also in this context, Dominguez (1998). 2Research at the IMF during this period, for instance, indicated that Japan’s external balances throughout 1985–90 responded to exchange rate changes in broadly the same way that they do in other countries, and in a pattern that was broadly consistent with estimated econometric relationships. See, in this context, Corker (1989) and Meredith (1993).

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Figure 11.1. Japan: Foreign Exchange Interventions in the Yen-Dollar Market1 (Yen per U.S. dollar) 150 140 130 120 110

Interventions to weaken yen Interventions to strengthen yen

100 90 80

Interventions to weaken yen 1995

96

97

98

99

2000

01

02

Copyright © 2003. International Monetary Fund. All rights reserved.

Source: WEFA. 1Shaded areas indicate the months in which the interventions occurred.

between early 2000 and August 2001, but then briefly spiked upward in the aftermath of the September 11 terrorist attacks, drawing heavy intervention from the authorities. The currency then resumed its downward path, reaching ¥134/$ in February 2002, but reversed course in the face of dollar weakness in world markets, and despite significant intervention to stem its rise, appreciated rapidly during April–July 2002. The foreign exchange interventions carried out in recent years raise a number of questions. How effective were the foreign exchange interventions? Did they have persistent effects on the yen-dollar rate? Were interventions more effective when coordinated than when conducted unilaterally? Did interventions to strengthen the yen have a greater chance of success than interventions to weaken the yen? Why did the Japanese authorities intervene much more frequently in the yen-dollar market than the U.S. authorities did, and what specifically triggers foreign exchange interventions? This chapter attempts to answer these questions, estimating an interest-rate arbitrage rational expectations model of the exchange rate with daily data, and a probit model of the probability of interventions. In contrast to recent studies—which have focused on the impact of interventions on exchange rate volatility (Dominguez, 1998, and Chang and Taylor, 1998), or have revisited the effectiveness of the Plaza Accord interventions (Humpage, 1999)— the

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focus of this chapter is on directly testing the impact of the interventions conducted in recent years on the level of the exchange rate. The main finding of the chapter is that the foreign exchange interventions have on the whole mattered, and have succeeded on a number of occasions in changing the path of the yen-dollar rate in the desired direction, even though the interventions in the yen-dollar market were routinely sterilized. Thus, contrary to the conventional wisdom that interventions can be effective only when left unsterilized, an important finding of the paper is that sterilized interventions appear to work—having a probability of success of about 50 percent. The chapter argues that sterilized interventions have been effective primarily because they influence market participants’ expectations of future economic fundamentals and the stance of monetary policy, and also erode bandwagon effects. Consistent with conventional wisdom, the chapter finds that coordinated interventions in the yen-dollar market have been more effective than unilateral interventions, having a probability of success of about 75 percent; when successful, coordinated interventions move the exchange rate in the desired direction by about 2–3 percent—about thrice as much as unilateral interventions do. While interventions have, on average, had relatively small effects on the yendollar rate, these effects tend to be persistent. However, it must be noted in this context that the model used for the estimations explains only a relatively small part of the day-to-day fluctuations in the yendollar rate, which like all asset prices, has a significant unexplained component to its movements. The chapter also finds that unilateral interventions by the Bank of Japan to weaken the yen have had a somewhat lower success rate than unilateral actions to strengthen the yen. It is interesting to note in this regard that the Bank of Japan intervenes much more frequently in the yen-dollar market than the Federal Reserve does, with much of the interventions aiming to stem yen appreciation. The chapter argues that the higher frequency of the Bank of Japan’s interventions is related to the fact that Japan’s nominal effective exchange rate, unlike that of the United States, moves in close synchronization with the yen-dollar rate; consequently, any strengthening of the yen against the dollar implies a stronger negative shock for the Japanese economy than an appreciation of the dollar against the yen does for the U.S. economy. The probit model used to estimate the triggers for interventions indicates that the Japanese authorities have in practice intervened to stem both an “excessive appreciation” and an “excessive depreciation” of the yen, just as they claim to do in their official pronouncements on exchange rate policy. And, finally, the estimations indicate that interventions in the yen-

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dollar market tend to occur in clusters, so that if there has been an intervention today, there is then a good chance that there will be another one tomorrow.

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Foreign Exchange Interventions in Practice A brief overview of how foreign exchange interventions are conducted in the yen-dollar market provides a useful starting point for analysis. In the case of Japan, the authorization of the foreign exchange operations, as well as the financing of interventions, is the responsibility of the Ministry of Finance.3 The Bank of Japan implements the actual intervention operations in the foreign exchange market. In the United States, both the Federal Reserve and the Treasury have independent legal authority to initiate foreign exchange interventions. Nevertheless, the primary responsibility in practice for initiating interventions has rested with the Treasury. The Federal Reserve implements the actual interventions through the operations of the Foreign Exchange Desk of the Federal Reserve Bank of New York. The financing of interventions is shared between the Treasury and the Federal Reserve.4 How can we identify specific interventions in the yen-dollar market? The data on the Federal Reserve’s intervention operations can be obtained after a lag of about a year. When the empirical work in this chapter was conducted, no official data on specific interventions by the Bank of Japan were published.5 Indicative information on interventions in the yen-dollar market can, however, be gleaned from the financial press, which provides prominent coverage of these operations soon after they take place. News reports of foreign exchange interventions tend to be highly reliable, particularly in the post–Plaza Accord period. Both the Federal Reserve and the Bank of Japan have for some years now conducted their intervention operations openly and directly in the dealer market, typically with the foreign exchange desks of large commercial banks. While central banks have the option of keeping their operations in the dealer market secret, they have typically chosen not 3The recent technical changes in the financing of foreign exchange interventions— the sale of finance bills issued by the Ministry of Finance to the public rather than to the Bank of Japan directly—has made no effective difference to how interventions are ultimately financed. 4See Cross (1998) for a more detailed description of how foreign exchange interventions are carried out in the United States. 5In July 2001, the Japanese Ministry of Finance released daily intervention data for April 1991 to March 2001, and is now updating this information four times a year.

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to do so, as the primary objective of the interventions has been to show a presence in the foreign exchange market and indicate a view about exchange rate trends. The interventions are usually reported soon after they occur on Reuters and other news agencies, and then receive prominent coverage in the financial press the next day. While some traders do learn of interventions before they appear on Reuters reports, this lag is usually less than 30 minutes in the yen-dollar market, so that for all practical purposes interventions become public knowledge soon after they are conducted. Sometimes official statements confirm interventions, but the Japanese authorities have typically not followed this practice.6 For this study, information on the occurrence of foreign exchange interventions in the yen-dollar market (by both the Bank of Japan and the Federal Reserve) during 1995–99 were collected from the electronic archives of the Financial Times and the Wall Street Journal. The news reports on interventions in these two newspapers were cross-checked with each other and also with other news sources. Sometimes there are reports in the financial press about either rumors or threats of interventions in the yen-dollar market. Reports of both rumors and threats of interventions were not included in compiling the data set on interventions, and only reports that specifically mention that central banks have intervened to either weaken or strengthen the yen were included. The data on foreign exchange interventions, thus, includes four categories of interventions conducted during 1995–99: (1) unilateral interventions by the Bank of Japan to weaken the yen; (2) coordinated interventions by the Bank of Japan and the Federal Reserve to weaken the yen; (3) unilateral interventions by the Bank of Japan to strengthen the yen; and (4) coordinated interventions by the Bank of Japan and the Federal Reserve to strengthen the yen. No instances of unilateral interventions by the Federal Reserve in the yen-dollar market were identified in news reports during this period. According to reports in the financial press, interventions in the yendollar market in the latter half of the 1990s were predominantly aimed at either preventing or reversing yen appreciation. Of these, unilateral interventions by the Bank of Japan to stop the yen from strengthening far outnumbered coordinated interventions. While we identified about 32 unilateral interventions by the Bank of Japan to prevent yen appreciation, there were only 6 such instances of coordinated interventions

6See Cross (1998), Chang and Taylor (1998), and Dominguez (1999) for a more detailed description of central bank intervention operations.

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by the Bank of Japan and the Federal Reserve. There were 9 instances of unilateral interventions by the Bank of Japan, and 2 instances of coordinated interventions by the Bank of Japan and the Federal Reserve to either prevent or reverse yen depreciation. It is, of course, likely that news reports failed to identify some of the interventions that did take place during this period and, also, some of the interventions that were reported to have taken place in the press may well have not have occurred in reality. But such errors of identification are likely to be small, given that central banks, as discussed earlier, have used interventions for explicitly signaling their presence in foreign exchange markets.

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Sterilized Versus Unsterilized Interventions The interventions in the yen-dollar market during this period have typically been sterilized—that is, not allowed to have an impact on the monetary base and interest rates. While there is no explicit information on whether particular interventions were sterilized or not, central banks in industrial countries have in practice routinely offset the impact of foreign exchange interventions on the stance of monetary policy, as monetary policy has typically been used for achieving low rates of inflation rather than for a particular exchange rate objective. In the case of Japan, for instance, the impact of both yen selling and buying operations ordered by the Ministry of Finance on domestic liquidity is offset by the open market operations of the Bank of Japan to maintain its desired level of daily excess reserves. Likewise, directives to the Foreign Exchange Desk of the Federal Reserve to sell dollars are simultaneously combined with directives to the Open Market Desk to mop up the resulting excess liquidity. This does not, however, imply that conditions in the foreign exchange market have had no influence on the monetary policy of industrial countries. Rather, the decision to change the stance of monetary policy, which could be influenced in part by exchange rate developments, has been separated in practice from the decision to intervene in the foreign exchange market. So, a test of the effectiveness of interventions in the yen-dollar market is, for all practical purposes, also a test of the effectiveness of sterilized interventions in this market. Why should sterilized interventions, contrary to conventional wisdom, be expected to have an impact on the yen-dollar rate? That sterilized interventions can work should not come as a surprise when viewed from a historical perspective. As noted before, academic studies indicate that sterilized interventions were successful in the post–Plaza Accord period. Nevertheless, the persistent skepticism about the effec-

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 231

tiveness of sterilized interventions in popular discourse appears to be based on a casual empiricism focusing on selective episodes of interventions, combined with an interpretation of the interest parity condition that plays down the importance of expectations in exchange rate determination. The interest parity condition is often invoked as the theoretical rationale for the assessment that interventions work only when left unsterilized. Uncovered interest rate parity in its strict form states that, in equilibrium, the currency of the country with a higher interest rate is expected by market participants to depreciate against the currency of the country with the lower interest rate over the relevant time horizon, so that investors are indifferent between holding the two currencies (see below). Under a simple view, sterilized intervention does not affect the interest rate differential, and therefore does not affect the exchange rate. By contrast, unsterilized interventions are expected to affect the exchange rate because they change interest rate differentials. However, because future expectations of the exchange rate enter the interest rate parity condition, the exchange rate is influenced not only by actual changes in monetary policy, but also by expectations of future changes in monetary policy. Consequently, even in the context of the interest rate parity condition, actions that provide signals about the future course of monetary policy should also have an impact on the exchange rate. Sterilized interventions can thus make a difference by providing signals to private agents about the future course of monetary policy.7 Indeed, one of the main aims of central banks in carrying out sterilized interventions is to change the path of exchange rates by altering market participants’ expectations of the future course of monetary policy and economic fundamentals. However, the signaling channel is less likely to be effective in situations where markets perceive that the central bank is not in full concurrence with the decision of the Ministry of Finance to intervene; sterilized interventions, in such situations, are likely to be less effective. While sterilized interventions can also be expected to have an impact on exchange rates by changing the currency composition of assets held by the private sector—the portfolio balance effect—central bank interventions are too small a fraction of the daily turnover in the foreign exchange markets (typically about 1 percent) for them to make

7A comprehensive discussion of the signaling role of sterilized interventions can be found in Mussa (1981). For a discussion of the signaling role of interventions in Japan, see Watanabe (1994).

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significant changes in the currency composition of assets held by the private sector. This is one of the reasons—besides the limited availability of daily data on the magnitude of the interventions—why the econometric strategy adopted in this chapter focuses on the number and types of interventions in the yen-dollar market rather than on the actual quantities of foreign exchange spent on interventions. Sterilized interventions can also be effective in circumstances where currencies stay persistently misaligned because bandwagon effects and collective action problems dominate the influence of fundamentals. Market players’ decisions in such situations are conditioned by what other participants are likely to do rather than by what the underlying economic conditions warrant. For example, such a situation could emerge when no private agent is willing to be the first to buy or sell a currency that he judges to be misaligned, because of imperfect information about the beliefs of other market participants or simply because he does not want to make the first move in a game theoretic “common knowledge” setting. Such misalignments can persist for a considerable length of time as it is individually rational in such circumstances for each market participant not to bet against the market. In these contexts, central banks can overcome the collective action problem by using sterilized intervention to signal their assessment of currency misalignment to the entire market.

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Interventions and the Exchange Rate This section provides a model of the exchange rate to empirically examine the impact of interventions on the yen-dollar rate. Interventions in this model work by providing information about the future course of monetary policy. The Model Consider a simple uncovered interest rate parity (UIP) equation for the exchange rate with no risk premium, where the expected change in the exchange rate over a k-period horizon is equal to the interest rate differential over the same horizon: E(et+k |Ωt) – et = it – i*t ,

(1)

where et is (the logarithm of) the price of the dollar in terms of yen, k is the maturity of the interest rate, and it and it* are, respectively, interest rates in Japan and in the United States. Rewriting this condition as

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 233

an equation for the current exchange rate without restricting the coefficients gives et = γ E(et+k|Ωt) + β(it – i*t).

(2)

Under UIP, γ would be equal to one and β equal to minus one. Equation (2), generalized further to include a risk premium term, is the basis of most recent econometric models of the exchange rate. These models are usually estimated by replacing the expected value of the exchange rate by its actual value (see, for example, Wadhwani, 1999). In this chapter we highlight the role of expectations by focusing on the rational expectations solution of equation (2). Under the assumption that γ is less than one, which is required for stability, the solution of equation (2) is ∞

et = β∑γ jE[it+j,k – i*t+j,k)|Ωt],

(3)

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j=0

where expectations of the interest rate differential appear in k-period sequences because the order of the rational expectations equation is k. The implied long-run coefficient of the interest rate differential in this equation is equal to β /(1 – γ ), which for γ < 1 would be negative. To compute future expectations of the interest rate differential, assume that this variable follows an autoregressive process and, as argued above, is also influenced by announcements of interventions over a relevant horizon. Past exchange rates could also influence perceptions about the future course of monetary policy and are included in the equation. Representing interventions by Dt , we have h

l

j

i=0

i=1

i=1

E[it+j,k – i*t+j,k|Ωt] = ∑αi(it–i – i*t–i) + ∑ψiet–i + ∑λiDt–i.

(4)

This simple formulation abstracts from explicitly incorporating expectations of future interventions on current interest rates.8 Substituting 8Given the discrete nature of the intervention variables and their dependence on past exchange rates (as modeled below), an explicit incorporation of their future expectations would make the model highly nonlinear and intractable (see Pesaran and Samiei, 1995).

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equation (4) into equation (3) gives a dynamic equation relating the exchange rate to its past values, current and past values of interest rate differentials, and intervention dummies. This equation would have the following general representation: n

m

p

i=1

i=0

i=1

et = ∑λt–iet–i + ∑δi(it–i – i*t–i) + ∑ηiDt–i.

(5)

Although this relationship is loosely derived from a rational expectations model, it does not impose the restrictions implied by rational expectations on the coefficients. Note also that while interventions in this model are assumed to operate primarily through their signaling effect regarding future interest rates, empirical support for the model would clearly not exclude the possibility that interventions could operate through other channels as well—for example, through the risk premium, as in Dominguez and Frankel (1993).

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Estimation of the Long-Run Relationship The model leading to equation (5) can be estimated using the vector autoregression (VAR) methodology. Since both the yen-dollar rate and the interest rate differentials appear to contain unit roots,9 it is necessary to test for a cointegrating VAR relationship. For simplicity, we do not include the intervention dummies in the long-run relationship, but only in the resulting short-run error correction model; including the dummies in the long-run relationship, however, makes little difference to the results. It is important to note in this context that since the yen-dollar rate is a nonstationary variable, any temporary shock to it will have an impact on its long-run path. Thus, a finding that interventions have an impact on the change in the yen-dollar rate during any particular period (see below) also implies that they have a long-run effect on the yen-dollar rate. Table 11.1 reports the results of the Johansen test for cointegration. The estimations indicate that there is one cointegrating relationship between the exchange rate and the interest rate differential that includes a trend and an intercept term. Thus, the two variables move together in the long run according to the following relationship: e = 0.165 (i – i*) + 0.0003t.

(6)

9Augumented Dickey-Fuller (ADF) tests of order 12 including an intercept and a linear trend give a value of –1.67 for the logarithm of the exchange rate and –2.83 for the interest rate differential, against a critical value of –3.42. ADF tests on first differences of the two variables give –10.63 and –11.58, respectively, against a 95 percent critical value of –3.42.

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Table 11.1. Cointegration Likelihood Ratio for the Yen-Dollar Rate Equation1

Null

Alternative

r=0 r≤1

r=1 r=2

Maximum Eigenvalue ______________________ 95 percent Statistic critical value 21.96 8.79

19.22 12.39

Trace ______________________ 95 percent Statistic critical value 30.74 8.78

25.77 12.39

1Based on cointegrating VAR of order 4, with unrestricted intercepts, and restricted trend, which includes both the yen-dollar rate and the interest rate differential as endogenous I (1) variables.

Note in this context that this result is not necessarily consistent with the strict UIP condition, which by requiring that γ equals unity implies a long-run relationship between the interest rate differential and the change in the exchange rate. Moreover, if γ < 1, as required by the stability condition for the rational expectations solution, then the relationship between the interest rate differential and the exchange rate should be negative. Although a positive coefficient for the interest rate differential is consistent with the findings of some other studies— which use lower-frequency data and/or have been estimated over different time periods10—restricting the coefficient to be small and negative is not rejected by the data, suggesting that a wide range of coefficients can give a cointegrating relationship. The multiplicity of potential cointegrating relationships, however, has little impact on the results on interventions in the next section.

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Error-Correction and Intervention Dummies The data on daily intervention in the yen-dollar market obtained from news reports during 1995–99 are classified into four categories: Type 1: Bank of Japan intervenes to weaken the yen (incidence 32 times) Type 2: Bank of Japan and the Federal Reserve intervene to weaken the yen (incidence 6 times) Type 3: Bank of Japan intervenes to strengthen the yen (incidence 9 times) Type 4: Bank of Japan and the Federal Reserve intervene to strengthen the yen (incidence twice) Representing each single intervention by a dummy variable should in principle allow us to test the effectiveness of every intervention made during this period. However, given the number of observations, 10See,

for example, Wadhwani (1999).

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adopting such a strategy would make the estimations unwieldy. On the other hand, distinguishing the interventions only by the above four broad categories would ignore the fact that not all interventions are equally effective. A close look at the data on interventions indicates that they tend to occur in clusters. Consequently, to better distinguish the effects of these clusters of interventions within each broad category, we subdivide them based on how they were bunched up during 1995–99. In the case of Type 1 interventions, we identify nine distinct intervention clusters, represented by nine dummies, D11 to D19, each taking the value one in the event of an intervention of Type 1 in that particular episode, and zero otherwise. In the case of Type 2 intervention, three episodes are identified, D21 to D23 ; in the case of Type 3 intervention, there are four episodes, D31 to D34 ; and finally in the case of Type 4 intervention, only one episode, D4, is identified. Thus, we define 17 intervention dummies altogether for the estimations. The expected signs of the coefficients on Type 1 and 2 dummies are positive, and negative on Types 3 and 4. The exchange rate data suggest the presence of an important outlier—that is, the substantial appreciation of the yen associated with the collapse of the carry-trades during August–October 1998. To isolate this effect, we include a carry-tradedummy—Dct—in the regressions to capture the largest exchange rate movements associated with this particular episode. Table 11.2 presents the estimated short-run error-correction model of the yen-dollar rate, with the error-correction term calculated using the cointegrating relationship derived above, and including the intervention dummies and their one-period lagged values. To highlight the impact of interventions on the yen-dollar rate, a parsimonious version of the model that includes only the correctly signed significant dummies is presented in Table 11.3. The results provide support for the hypothesis that interventions, on the whole, do make a difference to the yen-dollar rate, and that they have been successful on a number of occasions in changing the path of the exchange rate in the desired direction. Exclusion of the intervention dummies from the equation is strongly rejected by the data [F(34,1549)=3.74(0.00)]. Moreover, although as indicated by the R2, the estimated model explains only a small portion of the daily fluctuations in the yen-dollar rate, it clearly outperforms a simple random walk model, which would require that no variable have a significant influence on the change in the exchange rate.11 11This result holds even when the carry-trade-dummy—which contributes significantly to the value of the R2—is excluded. While the inclusion of this dummy variable is justified on economic and statistical grounds, it cannot be treated as a genuine explanatory variable, given that it is defined ex post.

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Table 11.2. Estimated Error Correction Model of Interventions Based on Cointegrating VAR

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Dependent variable is Δet 1,585 observations used for estimation from 5 to 1,589 Regressor C Dct D11 D11(–1) D12 D12(–1) D13 D13(–1) D14 D14(–1) D15 D15(–1) D16 D16(–1) D17 D17(–1) D18 D18(–1) D19 D19(–1) D21 D21(–1) D22 D22(–1) D23 D23(–1) D31 D31(–1) D32 D32(–1) D33 D33(–1) D34 D34(–1) D4 D4(–1) Δet (–1) Δet (–2) Δet (–3) Δ(it – it*) (–1) Δ(it – it*) (–2) Δ(it – it*) (–3) EC(–1) R2 =0.172 Standard error of regression = 0.0077 Mean of dependent variable = –0.24E–4 Residual sum of squares = 0.092 Akaike information criterion = 5,437.6 DW statistic = 2.028

Coefficient T-Ratio [Prob] –0.017 –2.56 [0.01] –0.074 –13.40 [0.00] 0.002 0.62 [0.54] –0.007 –2.31 [0.02] 0.008 1.55 [0.12] 0.003 0.55 [0.58] –0.003 –0.83 [0.41] –0.009 –2.32 [0.02] 0.000 0.02 [0.98] –0.002 –0.53 [0.60] 0.011 2.02 [0.04] 0.004 0.72 [0.47] 0.008 2.26 [0.02] –0.001 –0.38 [0.70] –0.003 –0.54 [0.59] –0.013 –2.09 [0.04] –0.012 –1.95 [0.05] 0.006 0.99 [0.33] –0.003 –0.46 [0.65] 0.011 2.01 [0.05] –0.002 –0.46 [0.64] –0.009 –1.92 [0.06] –0.003 –0.37 [0.71] 0.031 4.10 [0.00] 0.013 2.81 [0.01] 0.018 4.02 [0.00] 0.003 0.45 [0.65] –0.004 –0.46 [0.65] –0.003 –0.57 [0.57] –0.002 –0.39 [0.70] 0.006 1.42 [0.16] –0.009 –2.01 [0.05] –0.001 –0.13 [0.89] –0.009 –2.03 [0.04] 0.001 0.13 [0.90] –0.030 –4.70 [0.00] –0.070 –2.89 [0.00] –0.019 –0.82 [0.41] –0.070 –2.94 [0.00] –0.001 –0.41 [0.68] 0.000 0.04 [0.97] –0.009 –2.41 [0.02] 0.003 2.57 [0.01] – R2 = 0.149 F-statistic F (17,1567) = 7.62 [.000] Standard deviation of dependent variable = 0.0084 Equation log-likelihood = 5,480.6 Schwarz Bayesian criterion = 5,322.2

X2sc (1) = 1.418 [0.23] Test for serial correlation X2n (2) = 530.221 [0.00] Test for normality

X2ff (1) = 3.833 [0.05] Test for functional form X2he (1) = 0.431 [0.51] Test for heteroskedasticity

Note: The dependent variable Δe is the change in the logarithm of the yen-dollar rate. EC is the error correction term from the cointegrating VAR relationship. C is the constant. The Dis represent the dummies for different types of interventions as described in the text.

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Table 11.3. Parsimonious Estimated Error Correction Model of Interventions Based on Cointegrating VAR Dependent variable is Δet 1,585 observations used for estimation from 5 to 1,589 Regressor C– Dct D15 D16 D19(–1) D22(–1) D23 D23(–1) D33(–1) D34(–1) D4(–1) Δet (–1) Δet (–3) Δ(it – it*) (–3) EC(–1)

Coefficient 0.018 –0.074 0.011 0.008 0.011 0.032 0.010 0.018 –0.010 –0.009 –0.029 –0.062 –0.064 –0.009 0.003

R2 = 0.152 Standard error of regression = 0.0077 Mean of dependent variable = –0.24E–4 Residual sum of squares = 0.092 Akaike information criterion = 5,447.2 DW statistic = 2.00 X2sc (1) = 0.24E–4 [0.99] Test for serial correlation X2n (2) = 523.41 [0.00] Test for normality

T-Ratio [Prob] –2.67 [0.01] –13.27 [0.00] 2.08 [0.04] 2.30 [0.02] 2.03 [0.04] 4.12 [0.00] 2.23 [0.03] 3.98 [0.00] –1.99 [0.05] –2.02 [0.04] –5.28 [0.00] –2.58 [0.01] –2.74 [0.01] –2.41 [0.02] 2.67 [0.01]

– R2 = 0.145 F-statistic F( 17,1567) = 20.17 [.000] Standard deviation of dependent variable = 0.0084 Equation log-likelihood = 5,462.2 Schwarz Bayesian criterion = 5,406.9 X2ff (1) = 4.02 [0.05] Test for functional form X2he (1)= 0.305 [0.58] Test for heteroskedasticity

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Note: The dependent variable Δe is the change in the logarithm of the yen-dollar rate. EC is the error correction term from the cointegrating VAR relationship. C is the constant. The Dis represent the dummies for different types of interventions as described in the text.

While the residuals in the above specification fail the normality test—as would be expected with high-frequency exchange rate data— alternative methods of estimating the model to deal with this problem suggest that the results are quite robust. Since an F-test does not reject the presence of Autoregressive Conditional Heteroscedasticity (ARCH) type effects in the residuals (F(6,1536) = 26.01 [0.00]), the normality problem could be dealt with by estimating a Generalized ARCH (GARCH) model. We use the parsimonious specification of the model, as presented in Table 11.3, to estimate a GARCH(1,1) model. This model allows the conditional variance of the error term to depend on the absolute value of the residual in the previous period and its own lagged value, as well as the carry-trade-dummy.12 The results, reported in Table 11.4, indicate clearly that the significance of the inter12The alternative of including the square of the residuals instead of their absolute value caused computational difficulties.

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Table 11.4. Estimated GARCH(1, 1) Model of Interventions Dependent variable is Δet 1,585 observations used for estimation from 5 to 1,589 Regressor C Dct D15 D16 D19(–1) D22(–1) D23 D23(–1) D33(–1) D34(–1) D4(–1) Δet (–1) Δet (–3) Δ(it – it*) (–3) EC(–1)

Coefficient –0.020 –0.072 0.012 0.009 0.014 0.032 0.011 0.018 –0.012 –0.010 –0.029 –0.045 –0.039 –0.006 0.004

R2 = 0.150 Standard error of regression = 0.0078 Mean of dependent variable = –0.24E–4 Residual sum of squares = 0.095 Akaike information criterion = 5,548.9 DW statistic = 2.028

T-Ratio [Prob] –39.51 [0.00] –5.80 [0.00] 1.68 [0.09] 2.98 [0.03] 4.14 [0.00] 21.08 [0.00] 2.36 [0.02] 3.96 [0.00] –2.72 [0.01] –2.47 [0.01] –5.12 [0.00] –1.77 [0.08] –1.85 [0.06] –2.02 [0.04] 38.85 [0.00]

– R2= 0.141 F statistic F( 17,1567) = 16.27[.000] Standard deviation of dependent variable = 0.0084 Equation log-likelihood = 5,566.9 Schwarz Bayesian criterion = 5,500.5

Parameters of the Conditional Heteroskedastic Model Explaining H, the Conditional Standard Error of the Error Term

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Constant ABS (E(– 1)) H (– 1) Dct

Coefficient 0.260E–3 0.106 0.886 0.004

Asymptotic Standard Error 0.326E–4 0.015 0.011 0.003

Notes: H stands for the conditional standard error of the error term. E stands for the error term. The dependent variable Δe is the change in the logarithm of the yen-dollar rate. EC is the error correction term from the cointegrating VAR relationship. C is the constant. The Dis represent the dummies for different types of interventions as described in the text.

ventions dummies is essentially unaffected by allowing for ARCH effects in the residuals. The inference to be drawn from these estimation results is that interventions appear to have had a reasonable chance of success in the yen-dollar market, especially when they were coordinated. Out of the 17 episodes of interventions identified in the analysis, 8 appear to have led, within two days, to a significant movement of the exchange rate in the desired direction, and the remaining 9 are mostly associated with no significant movements in either direction. This is a particularly noteworthy result given that interventions are, by design, likely to take

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place when the exchange rate is moving in an undesired direction and, hence, create a tendency for the estimated coefficients to be wrongly signed. That is, even when an intervention succeeds partially in precluding the exchange rate from moving further in the undesired direction, one would not necessarily observe a correctly signed estimated coefficient on the dummy variables. The fact that we observe the estimated coefficients on the dummy variables to be correctly signed and significant in about 50 percent of the episodes is testament to the reasonable level of success achieved by interventions in the yen-dollar market. The results also indicate that coordinated interventions tend to be clearly much more effective than unilateral interventions when it comes to both strengthening the yen as well as weakening it. The least effective have been Type 1 interventions—attempts by the Bank of Japan to weaken the yen—with only three successful episodes (the coefficient of either the dummy or its lagged value is significant with the right sign at 5 percent rejection probability) out of a total of nine. All other categories of interventions appear to have had a higher success rate than Type 1 interventions. Two out of the three episodes of Type 2 intervention have been successful, as have been two of the four episodes of Type 3 interventions. The only episode of Type 4 intervention also proved effective. In particular, the two successful cases of coordinated interventions to weaken the yen lowered it by 2–3 percent against the dollar in each case (D23 and D33). In the case of interventions to strengthen the yen, the only episode of coordinated action succeeded in pushing up its exchange value by 3 percent (D4). Unilateral interventions, in contrast, are associated with smaller changes in the exchange rate, generally by about 1 percent or less. The fact that unilateral interventions by the Bank of Japan to strengthen the yen appear to have been somewhat more successful than interventions to weaken it poses interesting policy issues, given that interventions in the yendollar market have largely been unilateral actions by the Bank of Japan to weaken the yen. It is necessary to emphasize again that, given the nonstationarity of the exchange rate variable, the short-run effects of the interventions captured in the regressions have persistent effects on the yen-dollar rate. Also, the significance of the intervention dummies is quite independent of the nature of the long-run relationship discussed in the previous section.13 13In particular, the absence of clear support for the interest rate parity hypothesis has no bearings for the short-run model, and removing the error-correction term from the equation makes little difference to the estimation results.

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 241

The finding that coordinated interventions are probably more effective than unilateral ones can be related to the fact that the former provide signals about the future course of monetary policy in both countries, which is obviously of greater relevance to exchange rate determination. Moreover, coordinated interventions also provide implicit external sources of validation for the decision taken by each central bank to intervene and motivate market participants to assign a higher probability to the expectation that the signals will portend changes in the future course of monetary policy. Finally, an issue that is of interest to central bankers in this context is the so-called momentum factor. While interventions normally occur in response to unfavorable movements in the exchange rate, central banks, in making choices about the appropriate time to intervene, may prefer to wait for a misaligned currency to move spontaneously for a few days in the desired direction, so that intervention can make use of the momentum in the exchange rate to push it further in the desired direction. It could be argued that interventions are likely to have a higher chance of success when momentum is present than when the central bank tries to lean against the wind. Testing this hypothesis formally in the dummy variable setting is not straightforward. Including interaction terms involving the cumulative change in the yen-dollar rate over a period prior to intervention and the intervention dummies can produce correctly signed coefficients, which can, however, be the result of an ineffective intervention combined with prior movements of the exchange rate in the undesired direction (results not reported here). Given the ambiguities involved in using this methodology, an alternative approach is simply to check the data visually for the momentum factor. That, however, does not provide much support one way or the other about the importance of momentum. In particular, of the eight intervention episodes that appear to have been successful, only two or three could be considered to have taken place in an environment where the exchange rate was already moving in the desired direction for a reasonable period before intervention (Figure 11.2).

Triggers for Interventions There are two distinct sets of issues relating to the triggers for intervention in the yen-dollar market. The first is the question of why the Bank of Japan intervenes so much more frequently than the Federal Reserve in the yen-dollar market, particularly when it comes to stemming yen appreciation. The second revolves around the search for patterns in

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1995

1996

1997

Japan's Lost Decade : Policies for Economic Revival, International Monetary Fund, 2003. ProQuest Ebook Central,

1995

1996

1997

Sources: Bloomberg, LP; and IMF staff calculations.

1994

(Unilateral interventions to strengthen the yen)

Type III Interventions

1994

(Unilateral interventions to weaken the yen)

Type I Interventions

1998

1998

1999

1999

2000

2000

170 160 150 140 130 120 110 100 90 80 70

170 160 150 140 130 120 110 100 90 80 70 1995

1996

1997

1998

1994

1995

1996

1997

1998

(Coordinated interventions to strengthen the yen)

Type IV Interventions

1994

(Coordinated interventions to weaken the yen)

Type II Interventions

1999 2000

1999 2000



170 160 150 140 130 120 110 100 90 80 70

170 160 150 140 130 120 110 100 90 80 70

(Yen per U.S dollar)

Figure 11.2. Japan: Exchange Rate Interventions

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242 RAMANA RAMASWAMY AND HOSSEIN SAMIEI

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The Yen-Dollar Rate: Have Interventions Mattered?

 243

past exchange rate movements that can offer clues about when the probability of interventions is high. An intuitive answer to the question of why the Bank of Japan intervenes much more frequently than the Federal Reserve would be that the exchange rate matters more to the Japanese economy than it does to the U.S. economy. This would indeed be the case if foreign trade played a more important role in Japan than it did in the United States. However, the exposure of the Japanese economy to foreign trade is broadly similar to that of the United States. The average value of exports and imports expressed as a percentage of GDP—a standard measure of the degree of “openness”—was about 12 percent in Japan in the latter half of the 1990s, compared with about 14 percent in the United States. Even though the exposure of the Japanese economy to foreign trade is marginally lower than in the United States, it still happens to be the case that fluctuations in the yen-dollar rate have stronger effects on the former than they do on the latter. Figure 11.3 offers clues to the source of this puzzle. Japan’s nominal effective exchange rate (the exchange value of the yen against a weighted average of the exchange rates of trading partners) has tended to move closely in tandem with the yendollar rate. The dollar’s nominal effective exchange rate, in contrast, has moved quite independently of the yen-dollar rate. The reason for this dichotomy lies in the fact that Japan trades with a number of countries that have linked their currencies to the dollar. Consequently, every time that the yen strengthens against the dollar, it also strengthens against the other currencies that are fixed to the dollar, which has the effect of dampening the external sector’s support for the economy. Fluctuations in the yen-dollar rate, however, affect the U.S. economy only insofar as they affect trade with Japan. The relatively stronger impact of changes in the yen-dollar rate on the Japanese economy provides a plausible explanation for why the Bank of Japan intervenes much more frequently than does the Federal Reserve. What precisely sets off interventions in the yen-dollar market? Neither the Bank of Japan nor the Federal Reserve are in the practice of providing detailed explanations for why they intervened in particular instances. The Japanese authorities, however, emphasize in their public statements that they do not target any particular value of the exchange rate; they claim, instead, to intervene primarily for resisting both an “excessive appreciation” and an “excessive depreciation” of the yen. An interesting issue to examine, therefore, is whether episodes of rapid changes in the yen-dollar rate have in practice triggered interventions.

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Figure 11.3. Japan: Exchange Rate Comparisons Yen per U.S dollar 40

Index 1990=100 225 Japanese NEER (right scale)

60 80 100

175

Yen per U.S. dollar (left scale)

150

120

125

140 160

100

U.S. NEER (right scale)

180

75

200

50

220

25

240 260

200

1985 86

87

88

89

90

91

92

93

94

95

96

97

98

99 2000 01 02

0

Source: IMF, Information Notice System.

Probit models provide a useful econometric technique for identifying the triggers for intervention. In this setting, the intervention event, Dt, defined as a dummy that takes the value one in the event of intervention (of any type) and zero otherwise, could be considered the observed counterpart of the underlying smooth response variable, D*t, which responds linearly to variables such as the extent of the absolute change in the exchange rate during a specified period. Thus,

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D*t = θ'xt + ut ,

(7)

where xt is the set of exogenous variables that influence the response variable and ut is an error term. Then Dt= 1 if D*t ≥ 0; otherwise Dt = 0.

(8)

The system of equations (7) and (8) can be estimated by the maximum-likelihood method. The absolute value of the cumulative change in the yen-dollar rate over the previous five days is included as an explanatory variable. The change in the exchange rate on the same day of the intervention is excluded to avoid simultaneity problems. The estimations also include the lagged value of Dt, and the results are reported in Table 11.5. The estimated results of the probit model indicate that the Japanese authorities have in practice intervened to stem both an “excessive” ap-

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The Yen-Dollar Rate: Have Interventions Mattered?

 245

Table 11.5. Probit Model of Triggers for Interventions Dependent variable is the intervention dummy, D 1,583 observations used for estimation from 8 to 1,590 Regressor

Coefficient

T-Ratio [Prob]

C

–2.0646

–22.4899 [.000]

D (–1)

1.2102

5.8929 [.000]

AE

7.1924

1.9543 [.051]

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Factor for the calculation of marginal effects = 0.062756 Maximized value of the log-likelihood function = –207.9102 Mean of D = 0.032217 Pseudo-R2 = 0.077461 The dependent variable D denotes intervention of all types. C is a constant, and AE denotes the absolute change in the yen-dollar rate over a five-day period.

preciation and an “excessive” depreciation of the yen-dollar rate, consistent with their official pronouncements about exchange rate policy. It should be emphasized, however, that the probit model does not provide a complete explanation of the triggers for interventions. This is not surprising, given that the Japanese authorities are likely to be more comfortable with exchange rate fluctuations around certain levels of the yen-dollar rate than others, even though there are no official pronouncements about what these zones of comfort are. Consequently, movements in the yen-dollar rate over some ranges are unlikely to provoke interventions in practice. As discussed earlier, there could also be an asymmetry between how the Japanese authorities respond to yen appreciation and yen depreciation—being somewhat quicker to move when the yen appreciates than when it depreciates. Another factor that might explain the relatively low explanatory power of the probit model is related to the fact that the exchange rate can, at times, move autonomously in the direction desired by the Bank of Japan. For instance, the sharp appreciation of the yen following the collapse of the yen carry-trades during the global financial crisis in August 1998 is an example of a rapid and sustained change in the yen-dollar rate that did not initially warrant any interventions. The probit model indicates that interventions in the yen-dollar market tend to occur in clusters. Lagged intervention has a statistically significant coefficient, implying that if there has been an intervention today, then there is a good chance that there will be another one tomorrow.

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Conclusions With the economic recovery in early 2002 narrowly based on the strengthening of exports, the appreciation of the yen since March has raised concerns about its potential impact on the growth outlook and has prompted the authorities to intervene heavily in an attempt to stem its rise. The findings of this chapter indicate that there may be a role for foreign exchange interventions to counter the yen’s appreciation, given that interventions have succeeded on a number of occasions in the recent past in changing the path of the yen-dollar rate in the desired direction. Nevertheless, the impact that interventions can have on the economy needs to be put into the proper perspective, as the typical intervention when successful has a relatively small, though persistent, impact on the yen-dollar rate. Further, the disconcerting finding of the chapter in this context is that unilateral interventions by the Bank of Japan to weaken the yen have had somewhat less success in practice than its actions to strengthen the yen. Both the Bank of Japan and the Federal Reserve, like central banks in other industrial countries, routinely sterilize interventions. The fact that interventions in the yen-dollar market have made a difference implies that sterilized interventions, contrary to conventional wisdom, have mattered. The chapter has argued that sterilized interventions work by altering market participants’ expectations of the future course of monetary policy and economic fundamentals, and also by overcoming bandwagon effects. As the signaling effects of sterilized interventions are far more powerful than the portfolio effects, market perceptions of disagreements between central banks and the authorities in charge of intervention decisions have the potential to mute the effectiveness of interventions. The chapter also finds that coordinated interventions are more effective than unilateral interventions—they have a higher probability of success, and when successful move the yendollar rate by a larger margin (on average by about three times) than unilateral interventions do. The Bank of Japan intervenes more frequently in the yen-dollar market than the Federal Reserve does. This chapter has argued that the higher frequency of interventions by the Japanese authorities is in part related to the fact, that unlike in the United States, Japan’s nominal effective exchange rate moves in close synchronization with the yendollar rate. Consequently, when the yen strengthens against the dollar, it implies a stronger negative shock for the Japanese economy than an appreciation of the dollar against the yen does for the U.S. economy.

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 247

Official statements by the Japanese authorities often emphasize that they do not target any particular value of the exchange rate; instead, they claim to intervene primarily for resisting both an “excessive appreciation” and an “excessive depreciation” of the yen. The estimated probit model indicates that relatively large and sustained changes in the exchange value of the yen in either direction during 1995–99 did have a high probability of triggering interventions. And these interventions occurred in clusters—if there is an intervention today, there is a strong likelihood that there will be another one tomorrow.

References Chang, Yuanchen, and Stephen Taylor, 1998, “Intraday Effects of Foreign Exchange Intervention by the Bank of Japan,” Journal of International Money and Finance, Vol. 17 (February), pp. 191–210. Corker, Robert, 1989, “External Adjustment and the Strong Yen: Recent Japanese Experience,” Staff Papers, International Monetary Fund, Vol. 36 (June), pp. 464–93. Cross, Sam, 1998, “All About the Foreign Exchange Markets in the United States” (New York: Federal Reserve Bank of New York). Dominguez, Kathryn, 1998, “Central Bank Intervention and Exchange Rate Volatility,” Journal of International Money and Finance, Vol. 17 (February), pp. 161–90.

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———, 1999, “The Market Microstructure of Central Bank Intervention,” NBER Working Paper No. 7337 (Cambridge, Massachusetts: National Bureau of Economic Research). ———, and Jeffery Frankel, 1993, “Does Foreign-Exchange Intervention Matter? The Portfolio Effect,” American Economic Review, Vol. 38 (December), pp. 1356–69. Humpage, Owen, 1999, “U.S. Intervention: Assessing the Probability of Success,” Journal of Money, Credit and Banking, Vol. 31 (November), pp. 731–47. Krugman, Paul, 1991, “Has the Adjustment Process Worked?” Policy Analyses in International Economics No. 34 (Washington: Institute for International Economics). Meredith, Guy, 1993, “Revisiting Japan’s External Adjustment since 1985,” IMF Working Paper 93/52 (Washington: International Monetary Fund). Mussa, Michael, 1981, “The Role of Official Intervention,” Group of Thirty Occasional Paper No. 6 (New York: Group of Thirty). Pesaran, M. Hashem and Hossein Samiei, 1995, “Limited-Dependent Rational Expectations Models with Future Expectations,” Journal of Economic Dynamics and Control, Vol. 19 (November), pp. 1325–53. Wadhwani, Sushil, 1999, “Currency Puzzles” (London: Bank of England).

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Watanabe, Tsutomu, 1994, “The Signaling Effect of Foreign Exchange Intervention: The Case of Japan,” in Exchange Rate Policy and Interdependence: Perspectives from the Pacific Basin, ed. by Reuven Glick and Michael Hutchinson (Cambridge: Cambridge University Press), pp. 258–86.

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V

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JAPAN AND ASIA

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12 The Impact of Japanese Economic Policies on the Asia Region TIM CALLEN AND WARWICK MCKIBBIN

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T

he recession in Japan during 2001 has once again renewed the focus on the policies needed to bring about a sustained economic recovery. Prime Minister Koizumi has advocated an action plan focused on addressing the weaknesses in the banking sector, bringing about fiscal reform and consolidation, and accelerating structural reforms to raise productivity growth. There have also been calls for further monetary easing to arrest ongoing deflation. Because Japan is an important trading partner and supplier of capital to the Asian region, the implementation of such policies will have implications not only for the Japanese economy, but also for other countries in the region. This chapter examines the nature of the economic and financial relations between Japan and its regional neighbors, and then explores the possible impact of policies and developments—structural reforms that boost productivity, fiscal consolidation, monetary easing, and a loss of confidence in financial markets if reforms are not implemented—on the Japanese and regional economies.

Japan’s Economic and Financial Links with the Asia-Pacific Region Trade flows between Japan and other countries in the Asia region have undergone significant change since the mid-1980s. Japan has become increasingly reliant on Asia as a market for its exports and as a 251

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TIM CALLEN AND WARWICK MCKIBBIN

source of imports. The growth of Japanese exports to the Asia-9 countries has averaged 8!/2 percent a year (in U.S. dollar terms) since the mid-1980s, compared with aggregate export growth of 5!/4 percent a year, and the share of exports to these nine economies increased from an average of 27!/2 percent during 1986–91 to 38!/2 percent during 1996–2001 (Table 12.1).1 Asia is now the largest destination for Japanese exports, with Taiwan Province of China, Korea, Hong Kong Special Administration Region (SAR), and China being the most important destinations, while the United States and Europe have both declined in importance. Japan’s imports from Asia have also grown considerably, with 37 percent sourced from the region during 1996–2001, compared with 27#/4 percent during 1986–91. Imports from China, in particular, have shown remarkable growth, rising by an average of nearly 15 percent a year since the mid-1980s—more than twice the rate of growth of aggregate imports—and their share has risen from 5!/4 percent to 13#/4 percent of the total. Korea, Taiwan Province of China, and Indonesia are other important sources of imports. The shares of imports from the United States and Europe have both declined modestly. There have also been substantial changes in the composition of trade between Japan and Asia. Japan’s imports of machinery and transport equipment from the Asia-9 have increased from less than 5 percent of total imports in 1985 to nearly 35 percent, while other manufactured goods increased from less than 20 percent to 35 percent.2 Imports of fuel and other crude materials, on the other hand, have fallen substantially. While imports from most countries are heavily weighted toward machinery and transport equipment, those from China and Indonesia are mainly in the form of low-end consumer goods and raw materials, respectively. On the other hand, the composition of Japanese exports to Asia has remained largely unchanged, with machinery and transport equipment accounting for a little under 60 percent of the total, and other manufactured goods making up most of the remainder. While Japan remains a very significant trading partner, Asia has actually become relatively less reliant on Japan (although, given the significant increase in the importance of trade in the Asian countries in

1The Asia-9 are China, Hong Kong SAR, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan Province of China, and Thailand. 2Nakamura and Matsuzaki (1997) find that Asian companies have been very successful at penetrating the Japanese market for electrical machinery and other manufactured goods, partly at the expense of U.S. and European companies.

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5.1 5.8 4.3 3.2

5.7

2.1 1.4 1.5 0.7

3.3

Taiwan Province of China Korea Hong Kong SAR Singapore

ASEAN-4

Thailand Indonesia Malaysia Philippines

China

Japan's Lost Decade : Policies for Economic Revival, International Monetary Fund, 2003. ProQuest Ebook Central,

29.3 17.2

5.9

3.1 1.7 3.0 2.0

9.8

6.6 5.9 5.9 4.3

22.7

38.4

22.4 17.4

5.2

1.6 5.4 2.7 1.0

10.7

4.2 5.4 1.0 1.4

11.9

27.7

21.3 15.7

13.7

2.9 4.2 3.5 1.6

12.2

4.1 4.8 0.6 1.8

11.2

37.0

25.3 14.2

15.7

16.2 41.9 17.8 19.2

25.1

13.0 18.4 5.5 8.7

11.4

14.8

20.3 15.3

17.0

15.0 22.3 12.5 15.5

15.9

10.1 10.8 5.7 7.4

8.3

11.7

Asian Exports to Japan _______________________ 1986–91 1996–2001

(Percent of total exports or imports)

Japanese Imports from Asia _______________________ 1986–91 1996–2001

Source: Bank of Japan; and International Monetary Fund, Direction of Trade Statistics.

United States Europe

33.9 20.8

18.4

Newly industrialized countries

Memorandum:

27.5

Asia-9

Japanese Exports to Asia _______________________ 1986–91 1996–2001

Table 12.1. Trade Links Between Japan and Asia

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15.7 11.7

20.0

28.2 25.8 23.3 18.0

24.9

31.4 29.6 17.9 20.8

24.5

24.0

14.1 10.6

19.0

24.8 17.1 21.1 20.3

21.4

26.2 19.4 12.5 16.7

17.7

18.9

Asian Imports from Japan _______________________ 1986–91 1996–2001

The Impact of Japanese Economic Policies on the Asia Region

 253

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254



TIM CALLEN AND WARWICK MCKIBBIN

recent years, the absolute reliance has still increased).3 The share of Asian exports going to Japan has declined. During 1986–91, 14#/4 percent of exports from the Asia-9 went to Japan, but this share fell to 11#/4 percent during 1996–2001. The United States (22 percent) and Europe (15 percent) are both more important export destinations than Japan. Korea, Indonesia, Malaysia, and the Philippines have all greatly reduced their reliance on Japan, although for the ASEAN-4 and China, Japan remains an important destination.4 The importance of Japan as a supplier of goods has also declined, although it remains the single most important supplier to the region. During 1986–91, about one-fourth of the Asia-9’s imports came from Japan, but this declined to 19 percent during 1996–2001. In terms of financial flows, Japanese foreign direct investment (FDI) accelerated following the liberalization of capital controls in the early 1980s, and surged during the second half of the decade. This sharp rise reflected both the strong economic growth in Japan and in foreign markets, and the appreciation of the yen, which encouraged companies to relocate production overseas to maintain cost competitiveness (Bayoumi and Lipworth, 1998). Initially, the United States attracted most of this capital, with much of the investment being concentrated in the real estate, service, and finance and insurance sectors. However, the capital going to the Asia-9 countries also picked up—with Hong Kong SAR, Singapore, Thailand, and Indonesia seeing the largest share— and was more concentrated in the industrial sector. Japanese investment accounted for a significant proportion of total FDI flows to the Asia-9 countries (for which data are available) during the second half of the 1980s. Japanese FDI flows moderated significantly in the 1990s—particularly in the first half of the decade—as the sharp decline in asset prices in Japan and the subsequent slowdown in growth and balance sheet difficulties in the business sector took a toll. These weaker FDI flows, however, were largely the result of lower investment in the United States and Europe, and investment in Asia actually increased (although it did weaken sharply in 1999 and 2000 in the aftermath of the Asian crisis, before picking up again in 2001). Investment in this period was concentrated in Singapore, Thailand, and Indonesia, while from the mid3These developments have taken place in the context of a near doubling in the share of world trade accounted for by Asian countries since the mid-1980s, and a decline in Japan’s share of world trade. 4The country breakdown of Chinese trade data needs to be treated with caution, particularly for industrial countries, as trade with these countries is classified as trade with Hong Kong SAR if it passes through Hong Kong ports.

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The Impact of Japanese Economic Policies on the Asia Region

 255

1990s investment into China also accelerated (Table 12.2).5 However, despite the greater concentration of Japanese FDI in the Asia region, the relative importance of Japanese investment to these countries declined during 1996–2001 (to about 16 percent of the total). Japanese FDI to Asia has been focused in the industrial sector—particularly the electrical machinery sector in the second half of the 1990s—and has implied a movement of productive capacity out of Japan to the recipient countries. Consequently, these investments are likely to have had important implications for the pattern of trade between the countries. Indeed, Bayoumi and Lipworth (1998) find evidence that both FDI flows and stocks have a significant impact on imports from the recipient country to Japan, but that only FDI flows have an impact on exports from Japan to the recipient country. They argue this is consistent with the view that while FDI permanently raises imports from the recipient country to Japan, it only temporarily raises Japanese exports largely through the short-term need to equip new factories. Kawai (1998), however, argues that FDI has a permanent impact on both imports and exports, although the impact on imports is larger. Portfolio flows between Japan and the region have been more twoway than has FDI, because of investments in Japan from the regional financial centers of Hong Kong SAR and Singapore. Indeed, stock data show that Japan was in a net portfolio liability position with the rest of Asia at end-2001. With respect to other countries, investments have generally been small, with the exceptions of Malaysia and Thailand. Japanese banks were large lenders to Asian countries during the second half of the 1980s and early 1990s.6 According to BIS data, the outstanding stock of lending by Japanese banks to the Asia-9 countries rose from $140 billion in 1985 to a peak of $333 billion in 1994. The largest recipients were the regional financial centers of Hong Kong SAR and Singapore, although all destinations except Taiwan Province of China, Malaysia, and the Philippines experienced significant growth in lending. During 1991–95, Japanese banks are estimated to have supplied over 60 percent of the total outstanding international bank lending to Hong 5At end–2001, 17 percent of the outstanding stock of Japanese FDI (at market prices) was in the Asia-9, compared with 47 percent in the United States and 23 percent in Europe. Within Asia, Japanese FDI is largely concentrated in Singapore, China, and Thailand. 6This discussion is based on BIS data. As noted by Kohsaka (1996), there are significant two-way financial flows between Japan, Hong Kong SAR, and Singapore in their roles as international and regional financial centers. The data for Singapore and Hong Kong SAR therefore likely overestimate the impact on domestic resource use in these countries.

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280 267 1,047 691

1,561

565 504 378 113

459

ASEAN-4

Thailand Indonesia Malaysia Philippines

China

Japan's Lost Decade : Policies for Economic Revival, International Monetary Fund, 2003. ProQuest Ebook Central,

27,699 8,742 7,456

1,492

1,186 878 368 454

2,887

287 517 646 762

2,212

6,591

... ... ...

...

41.2 17.2 ... ...

–314

32.4 38.0 ... 20.7

...

...

... ... ...

8.3

28.1 12.4 12.6 21.8

4,654

15.6 8.5 ... 22.6

...

...

. . . .

. . . .

. . . .

. . . .

14,684 16,711 –9,799

–287

. . . .

45,136

. . . .

131

–471

26,627 4,564 –37,096

475

2,002 938 1,526 188

44,353

463 –904 –6,552 –1,968

–8,960

–3,831

... ... ...

14,186

20,535 17,869 5,432 1,301

56.4

4,055 14,799 121,755 84,684

225,293

284,616

... ... ...

14,205

19,638 15,285 6,706 2,725

38.5

2,854 15,110 46,676 34,003

98,642

157,201

... ... ...

50.3

62.8 60.3 52.1 17.8

25.6 41.4 64.4 56.9

57.9

57.3

... ... ...

31.1

52.9 35.8 35.2 17.4

15.1 28.4 35.8 29.7

31.0

32.8

Lending by Japanese Banks to Asia ___________________________________________ (Percent of foreign (U.S. dollars, millions) bank lending) 1991–95 1997–2000 1991–95 1997–2000

Sources: Bank of Japan, Balance of Payments Monthly; CEIC database; and Bank for International Settlements, Consolidated Banking Statistics.

39,273 20,251 8,635

2,285

Taiwan Province of China Korea Hong Kong SAR Singapore

Memorandum: World United States Europe

4,304

Newly industrialized countries

Share of Japanese FDI Portfolio Investment Flows in Host Country Between Japan and Asia __________________ _____________________ (Percent) (U.S. dollars, millions) 1986–91 1996–2001 1988–91 1996–2001



Asia-9

Japanese FDI to Asia ______________________ (U.S. dollars, millions) 1988–91 1996–2001

Table 12.2. Financial Links Between Japan and Asia

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256 TIM CALLEN AND WARWICK MCKIBBIN

The Impact of Japanese Economic Policies on the Asia Region

 257

Kong SAR, Thailand, and Indonesia. It is likely that at least part of this increase was associated with financing Japanese subsidiaries operating in these countries. With the onset of their financial difficulties and the emergence of a significant Japan premium, however, Japanese banks have withdrawn from Asian markets since 1995, a process accelerated by the Asian financial crisis. While this has been part of the trend toward a lower exposure to bank finance by the Asian countries since the financial crisis, Japanese banks have withdrawn at a faster pace than banks of other nationalities, and the share of Japanese bank lending to the region has declined to about 30 percent, although they are still estimated to be the largest (identified) lender to eight of the nine countries.7

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Impact of Reforms on the Japanese and Asian Economies While the importance of trade and financial links with Japan has declined for Asian countries, they remain important, and consequently economic developments in Japan continue to have important implications for other countries in the region. Thailand, the Philippines, and Indonesia are at the high end in terms of reliance on Japan, while Singapore and Hong Kong SAR are at the low end. Given these linkages, an analysis of the implications of developments and policies in Japan on the Asia-Pacific region needs to be undertaken with a model that adequately captures the interrelationships. The G-cubed (Asia-Pacific) model—based on the theoretical structure of the G-cubed model outlined in McKibbin and Wilcoxen (1998)—is well suited for such analysis, having both a detailed country coverage of the region and rich links between the countries through goods and asset markets.8 In this section, simulations of the G-cubed (Asia-Pacific) model are used to assess the implications of policies and risks in Japan for the domestic and regional economies.9

7This conclusion needs to be qualified, however, for China, Singapore, and Korea, where there is a large unidentified component (larger than the exposure of Japanese banks) in the country breakdown of outstanding lending. For China, and possibly Singapore, these are related to Hong Kong SAR banks, which, while included in the aggregate data, are not separately identified, for confidentiality reasons. 8A number of studies—summarized in McKibbin and Vines (2000)—have shown that the G-cubed model has been useful in assessing a range of issues across a number of countries since the mid-1980s. Full details of the model, including a listing of equations and parameters, can be found on the Internet: http://www.msgpl.com.au/msgpl/ apgcubed46n/index.htm. 9In all the simulations, the Bank of Japan and other central banks are assumed to follow a fixed money stock rule.

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Structural Reforms That Boost Productivity Growth in Japan The implementation of a broad range of structural reforms—such as those discussed in Chapter 5—would be expected to boost productivity growth in Japan. To assess the potential impact of such policies, a simulation is considered in which the expected growth rate of labor augmenting technical change is increased (relative to baseline) by 3 percent a year for 3 years, and 1 percent a year for another 8 years, before returning to trend after 11 years (this is modeled to broadly reverse the decline in productivity that took place during the 1990s). Following the positive shock to productivity, real GDP in Japan immediately increases relative to the baseline, although the impact on growth is initially limited by two factors (Figure 12.1). First, because there will be more Japanese goods available globally in the long run, the relative price of these goods falls—that is, the long-run real exchange rate (the relative price of Japanese goods) depreciates. Forward-looking Figure 12.1. Japan: Effects of an Increase in Productivity Growth

18 15

Real Effects

Interest Rates

Percent deviation from baseline

Percent point deviation from baseline

3

Real GDP

12 9

Nominal 10-year bond yield

1 Consumption Investment

0

0 –1

–3 Copyright © 2003. International Monetary Fund. All rights reserved.

Real short-term interest rate

2

6 3

–6

4

0

1.0

1

2

3

4

5

6

7

8

9 10 11

–2

0

1

2

3

4

5

6

7

8

9 10 11

Inflation

Tobin's q

Percent point deviation from baseline

Percent deviation from baseline

16

0.5

12

0

8

–0.5

CPI inflation

PPI inflation

0

–1.5

–4

–2.0

–8

–2.5

–12

1

2

3

4

5

6

7

8

9 10 11

Capital goods sector

4

–1.0

0

Real 10-year bond yield

Nondurables

0

1

2

3

4

5

6

Source: IMF staff estimates.

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8

9 10 11

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financial markets understand this outcome, and the exchange rate actually depreciates in the short run, raising inflation and inducing a tightening of monetary policy. Second, because of the expected rise in future labor productivity, there is a substitution in the production process away from capital and other inputs toward labor, which, in the short run, causes investment to fall. This fall is reinforced by the price effect from the exchange rate depreciation, which makes imported capital goods more expensive. However, as the initial fall in investment peters out in the second year after the shock, the impact of the increase in productivity is fully felt and real GDP begins to rise sharply, increasing 15 percent above the baseline after 10 years. The increase in productivity in Japan has a negligible impact on the regional economies in the short term (Figure 12.2). The depreciation of the yen reduces their competitiveness, offsetting the increase in production in Japan, which raises the demand for intermediate inputs, and the higher real income, which increases the demand for final goods. However, over time, the increase in activity in Japan dominates the impact of the higher real exchange rate, and real GDP in the regional economies rises above the baseline, although there is some reallocation of capital toward Japan that acts to reduce the positive spillovers. The largest growth impact is felt in the Philippines, Taiwan Province of China, and Malaysia.

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Fiscal Consolidation Prime Minister Koizumi has stressed the importance of fiscal consolidation, limiting the net issuance of Japanese government bonds (JGBs) to ¥30 trillion in FY2001, and suggesting a medium-term objective of achieving primary budgetary balance by the early 2010s. To assess the possible implications of such a policy, the impact of a phased, fully credible, fiscal consolidation is considered, where government expenditure is reduced by 1.7 percent of GDP in the first year, 3.4 percent of GDP in the second year, and 5 percent of GDP from the third year onward (relative to baseline).10 The reduction in government spending reduces aggregate demand through conventional Keynesian channels. However, in the model, the effects of the policy on anticipated future fiscal deficits is also important. In response to the announcement of a fully credible fiscal consolidation 10While any consolidation would not happen this quickly, for the purposes of the simulations it is useful to have it occurring in a relatively short period of time so that the competing effects of the policy become more clearly visible.

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Figure 12.2. Asia: Effects of an Increase in Japanese Productivity Growth

18

Real GDP

Real GDP

Percent deviation from baseline

Percent deviation from baseline

15

3

Japan

12

Korea China Singapore Hong Kong SAR

9 6 3

2 Indonesia

1

0 1 2 3 4 5 6 7 8 9 10 11

–1

Real Effective Exchange Rates Korea

Hong Kong SAR

4 0 –4 –8 –12

China

2

–20

Philippines Taiwan Province of China

6 4

Japan

–16

Malaysia Thailand Indonesia

0

–24 –28

Copyright © 2003. International Monetary Fund. All rights reserved.

Percent deviation from baseline

10 8

Singapore

0 1 2 3 4 5 6 7 8 9 10 11

Real Effective Exchange Rates

Percent deviation from baseline

8

Malaysia Taiwan Province of China Thailand Philippines

0

0 –3

4

0 1 2 3 4 5 6 7 8 9 10 11

–2

0 1 2 3 4 5 6 7 8 9 10 11

Real Long Bond Rates

Real Long Bond Rates

Percent point deviation from baseline

Percent point deviation from baseline

0.75

0.04 0

0.50

Indonesia

–0.04 0.25 Singapore

Japan

China

–0.25 –0.50

Hong Kong SAR

–0.08 –0.12

0 Korea

Malaysia Thailand

–0.16

Taiwan Province of China Philippines

–0.20 –0.24 0 1 2 3 4 5 6 7 8 9 10 11

0 1 2 3 4 5 6 7 8 9 10 11

Source: IMF staff estimates.

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plan, real interest rates fall as financial markets react to the lower expected future deficits, and the yen depreciates by about 15 percent as capital flows overseas in response to the decline in interest rates (Figure 12.3). As households anticipate lower future tax obligations, consumption rises, while the exchange rate depreciation boosts net exports. These factors more than offset the declines in government expenditure and private investment—the latter owing to the lower expected growth during years 2–4, which pushes down equity prices—and real GDP rises in the first year. Because inflation rises in response to the depreciation and the pickup in growth, short-term interest rates rise (if interest rates did not rise, the initial output response would be even more positive). However, real GDP falls below baseline in the second and third years as the positive impact from the financing gains is more than offset by the decline in government spending, and it is only from the fifth year that

Figure 12.3. Japan: Effects of a Phased Fiscal Consolidation

4 3

Real Effects

Inflation and Interest Rates

Percent deviation from baseline

Percent point deviation from baseline

Investment

2 1

Copyright © 2003. International Monetary Fund. All rights reserved.

0

Consumption Real GDP

3 2

Real short-term interest rate

1

CPI Inflation Real 10-year bond yield

0

–1

–1

–2

–2

4

0 1 2 3 4 5 6 7 8 9 10 11

Nominal10-year bond yield 0 1 2 3 4 5 6 7 8 9 10 11

Exchange Rates

Tobin's q

Percent deviation from baseline

Percent deviation from baseline

0

12 9

-4

6

-8 3

–12 –16 –20 –24

Nominal $US/yen

Capital goods sector

0 Nondurables

Real $US/yen 0 1 2 3 4 5 6 7 8 9 10 11

–3 –6

0 1 2 3 4 5 6 7 8 9 10 11

Source: IMF staff estimates.

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GDP once again moves above the baseline as the positive impact of the decline in real interest rates and the real exchange rate on consumption, investment, and net exports is fully felt. Because the fiscal consolidation is fully credible, the short-term output cost is less than in the case where the authorities’ commitment is not believed. In this case the initial positive impact felt though real interest rates, the exchange rate, and the decline in household saving is not forthcoming to mitigate the contractionary impulse from the decline in government spending (see Callen and McKibbin, 2001, for more details). The relative trade reliance on Japan and the size of the external debt stock determines the transmission of the decline in government expenditure in Japan to other countries in the region. In the short term, there is only a small impact on other Asian countries (Figure 12.4). While some countries see a small negative impact in the short run as the initial increase in demand in Japan is offset by the loss of competitiveness from the depreciation of the yen, countries with high debt levels (such as Indonesia) actually see an increase in real GDP. In the second year, all the Asian economies are gaining more from lower capital costs than they are losing from a temporary slowdown in Japan and the weaker yen, and the benefits over the medium term are estimated to be considerable.

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Quantitative Monetary Easing In an attempt to combat ongoing deflation, the Bank of Japan moved to a quantitative monetary framework in March 2001, and increased its purchases of long-term government bonds. While this has moved policy into uncharted waters, and consequently is difficult to quantify, the G-cubed model provides an insight into the possible transmission mechanism both in Japan and across the region. In this simulation, the Bank of Japan is assumed to purchase government bonds sufficient to bring about a permanent 1 percent increase in the money supply relative to the baseline. The monetary injection raises inflation expectations and consequently lowers short-term real interest rates (nominal interest rates, of course, are constrained by the zero bound) and depreciates the exchange rate (Figure 12.5). The decline in real interest rates and rise in equity prices temporarily stimulates private consumption and investment and the yen depreciation temporarily boosts net exports. The result is a temporary rise in real GDP through standard Keynesian channels––a demand stimulus accompanied by a fall in real wages and real interest rates temporarily increasing aggregate supply. Over time, however, price adjustment re-

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The Impact of Japanese Economic Policies on the Asia Region

Figure 12.4. Asia: Effects of a Phased Fiscal Consolidation in Japan

3.0 2.5 2.0 1.5 1.0 0.5 0 –0.5 –1.0 –1.5

Real GDP

Real GDP

Percent deviation from baseline

Percent deviation from baseline

2.5 Hong Kong SAR Korea

2.0

Singapore China

1.5 1.0

Malaysia Taiwan Province of China

0.5 Japan

0

1

2

3

4

5

6

7

Indonesia Thailand

0 8

9 10 11

–0.5

0 1 2 3 4 5 6 7 8 9 10 11

Real Effective Exchange Rates

Real Effective Exchange Rates

Percent deviation from baseline

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6 3 0 –3 –6 –9 –12 –15 –18 –21

0.1

Korea

Hong Kong SAR

–0.2 –0.3

China

Singapore

Taiwan Province of China

4 3 2 Malaysia

1

Japan

Thailand Indonesia

0 0

1

2

3

4

5

6

7

8

9 10 11

–1

0 1 2 3 4 5 6 7 8 9 10 11

Real Long Bond Rates

Real Long Bond Rates

Percent point deviation from baseline

Percent point deviation from baseline

China Hong Kong SAR Korea Singapore Japan

–0.4 –0.5

Philippines

5

0 –0.1

Percent deviation from baseline

6

0 1 2 3 4 5 6 7 8 9 10 11

0.04 0.02 0 –0.02 –0.04 –0.06 –0.08 –0.10 –0.12 –0.14

Taiwan Province of China Malaysia

Thailand

Philippines 0

1

2

3

4

5

Indonesia 6

7

Source: IMF staff estimates.

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Figure 12.5. Japan: Effects of a 1 Percent Monetary Expansion

0.40 0.35 0.30 0.25 0.20 0.15 0.10 0.05 0 –0.05

Real Effects

Inflation and Interest Rates

Percent deviation from baseline

Percent point deviation from baseline

Real GDP

Investment Consumption

0 1 2 3 4 5 6 7 8 9 10 11

0.6 0.5 0.4 0.3 0.2 0.1 0 –0.1 –0.2 –0.3 –0.4 –0.5

Real short-term interest rate Nominal 10-year bond yield

Real 10-year bond yield CPI inflation 0 1 2 3 4 5 6 7 8 9 10 11

Exchange Rates

0.25

(Downward movement represents appreciation of US$)

Tobin's q

Percent deviation from baseline

Percent deviation from baseline

0.8

0 –0.25

1.0

Capital goods sector

0.6 Real $US/yen

–0.50

0.4 Nondurables

0.2 –0.75

Nominal $US/yen

–1.00

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–1.25

0 –0.2

0 1 2 3 4 5 6 7 8 9 10 11

–0.4

0

1

2

3

4

5

6

7

8

9 10 11

Source: IMF staff estimates.

moves the real effects of the monetary shock and the economy settles down to the original baseline with higher prices but not higher inflation, because the shock is a rise in the level of money balances (a shock to the rate of growth of money results in a larger stimulus to demand, but also a permanent change in the underlying inflation rate in Japan). Long-term interest rates change little because the inflationary impulse is temporary, while the change in the real exchange rate that stimulates net exports is largely eroded by the second year. The effects on the rest of Asia are small (Figure 12.6). The temporary boost to aggregate demand leads to an increase in the demand for Asian goods in Japan, but this is offset by the rise in the price of these goods when converted into yen within the Japanese economy. Indeed,

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The Impact of Japanese Economic Policies on the Asia Region

Figure 12.6. Asia: Effects of a 1 Percent Monetary Expansion

0.40 0.35 0.30 0.25 0.20 0.15 0.10 0.05 0 –0.05

0.2 0.1 0

Real GDP

Real GDP

Percent deviation from baseline

Percent deviation from baseline

Japan China Hong Kong SAR Korea Singapore

0 1 2 3 4 5 6 7 8 9 10 11

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Philippines

0.002 0

–0.004

Indonesia 0 1 2 3 4 5 6 7 8 9 10 11

(Downward movement represents depreciation)

Percent deviation from baseline Korea Singapore China Hong Kong SAR

Japan

0 1 2 3 4 5 6 7 8 9 10 11

0.16 0.14 0.12 0.10 0.08 0.06 0.04 0.02 0 –0.02

Percent deviation from baseline

Indonesia Malaysia Taiwan Province of China Philippines Thailand

0 1 2 3 4 5 6 7 8 9 10 11

Real Long Bond Rate

Real Long Bond Rate

Percent point deviation from baseline

Percent point deviation from baseline

0.24

0.16

Malaysia Indonesia Thailand

0.12

Philippines

0.20

0.002

Singapore China Hong Kong SAR

0 Korea

–0.002

–0.006

Thailand

0.004

Real Effective Exchange Rates

–0.5

–0.004

0.006

(Downward movement represents depreciation)

–0.4

0.004

Malaysia Taiwan Province of China

Real Effective Exchange Rates

–0.2

–0.6

0.008

–0.002

–0.1 –0.3

0.010

Japan

0.08

Taiwan Province of China

0.04 0

0 1 2 3 4 5 6 7 8 9 10 11

–0.04

0 1 2 3 4 5 6 7 8 9 10 11

Source: IMF staff estimates.

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in the first year, the exchange rate effect dominates, and exports from each Asian economy to Japan—and into third markets in which they compete with Japanese goods—fall. In the second year, the demand stimulus in Japan has not declined as quickly as the real exchange rate, and therefore Asian exports are higher than in the baseline for several more years. Despite the export response being negative for growth in Asian economies in the first year, real GDP is broadly unchanged as equity prices rise in anticipation of the growth in periods 2 through 5, which raises private wealth and consumption sufficiently to offset the export decline. Of course, the numerical results from the simulations are subject to considerable uncertainty in the current economic environment (for example, the behavior of velocity, which is assumed to remain constant in the simulation, is very difficult to predict under such a quantitative easing scenario), while the model is obviously unable to address the questions of whether an increase in the Bank of Japan’s quantitative target could actually be achieved through stepped-up purchases of government bonds and whether, in the presence of a weak banking system, a higher quantitative target would affect the real economy. However, the simulation suggests that the primary transmission channels of such a bond purchase would be through inflation expectations, the exchange rate, and equity prices. Further, it suggests that if part of an overall monetary easing that was successful in boosting the Japanese economy, a depreciation of the yen would have a minimal impact on other regional economies.

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A Loss of Confidence in the Yen If investors perceive that the reforms needed to restore healthy growth in Japan over the medium term are not being implemented, thus increasing the risk of a further round of financial difficulties in the banking sector and raising questions about the sustainability of public debt, there could be a significant outflow of capital. This possibility is modeled by assuming that the risk premium on all Japanese assets increases by 3 percentage points relative to baseline (this is done in the interest parity condition between yen- and U.S. dollar–denominated government bonds).11

11The model includes risk premia on certain assets calibrated to be equal to whatever is required to make the model-generated asset returns equal to the observed returns in the base year (1999). These risk premia are held constant during the simulations unless they are exogenously changed (as in the current simulation).

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The increase in the risk premium on Japanese assets results in a substitution out of yen assets and into foreign assets. Consequently, longterm real interest rates rise, equity prices decline, and the yen depreciates by about 45 percent as capital flows out of Japan (Figure 12.7). The decline in equity prices results in a decline in Tobin’s q, which causes investment to fall, while consumption is also adversely affected by the decline in private wealth. While the yen depreciation boosts competitiveness and net exports, this is not sufficient to offset the decline in consumption and investment, and activity declines significantly. The impact on other countries in the region is broadly neutral in the first year, but positive thereafter (Figure 12.8). Again, a number of things are happening. Countries benefit from the lower capital costs Figure 12.7. Japan: Effects of a Loss in Confidence in the Yen

Copyright © 2003. International Monetary Fund. All rights reserved.

2 0 –2 –4 –6 –8 –10 –12 –14 –16

Real Effects

Inflation and Interest Rates

Percent deviation from baseline

Percent point deviation from baseline

4 Consumption

3

Real short-term interest rate Nominal 10-year bond yield

Consumption

2 Real GDP Investment 0 1 2 3 4 5 6 7 8 9 10 11

1 Real 10-year bond yield

0 –1

0 1 2 3 4 5 6 7 8 9 10 11

Exchange Rates

10

(Downward movement represents appreciation of US$)

Tobin's q

Percent deviation from baseline

Percent deviation from baseline

0

0

–20

–20

–40 –50

Nondurables

–10

–10

–30

10

–30 Nominal $US/yen Real $US/yen 0 1 2 3 4 5 6 7 8 9 10 11

Capital goods sector

–40 –50 –60

0

1

2

3

4

5

6

7

Source: IMF staff estimates.

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9 10 11



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Figure 12.8. Asia: Effects of a Loss in Confidernce in the Yen Real GDP

Real GDP

Percent deviation from baseline

Percent deviation from baseline

10 Hong Kong SAR

6

Korea

Malaysia Taiwan Province of China

4

0

Singapore China

–5

Japan

–10

3 2

Philippines Indonesia

1

–15 –20

Thailand

5

5

0 0 1 2 3 4 5 6 7 8 9 10 11

–1

0 1 2 3 4 5 6 7 8 9 10 11

Real Effective Exchange Rates

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5 0 –5 –10 –15 –20 –25 –30 –35 –40

1.50

Percent deviation from baseline

Hong Kong SAR China Singapore

0.25

Japan

6 4

Thailand

Malaysia Taiwan Province of China

0

Indonesia

–2 0

1

2

3

4

5

6

7

8

9 10 11

–4

0

1

2

3

4

5

6

7

8

9 10 11

Real Long Bond Rates

Real Long Bond Rates

Percent point deviation from baseline

Percent point deviation from baseline

Japan

Hong Kong SAR Korea Singapore China

0 –0.25 –0.50

Philippines

8

2

0.75 0.50

Percent deviation from baseline

12 10

Korea

1.25 1.00

Real Effective Exchange Rates

0 1 2 3 4 5 6 7 8 9 10 11

0.05 0 –0.05 –0.10 –0.15 –0.20 –0.25 –0.30 –0.35 –0.40

Malaysia

Taiwan Province of China Thailand Philippines Indonesia 0

1

2

3

4

5

6

7

Source: IMF staff estimates.

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The Impact of Japanese Economic Policies on the Asia Region

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caused by the additional inflow of capital (the mirror of the outflows from Japan), which stimulates investment and helps economies with high foreign debt levels. However, exports are negatively affected, although countries that sell goods to the domestic Japanese market are more affected than those that sell inputs for exports because the slowdown in Japan is asymmetric within the economy: exporting firms gain from the weaker yen whereas firms focused on the domestic economy suffer. In addition, countries that compete with Japan in third markets will lose competitiveness because of the yen depreciation. Adding these effects together, all Asian countries gain in terms of GDP.

Copyright © 2003. International Monetary Fund. All rights reserved.

Conclusions and Policy Implications This chapter has highlighted a number of important issues in understanding the transmission of shocks between Japan and the Asia-Pacific region. Because trade and financial linkages are significant, developments are transmitted across countries through both goods and asset markets, and the adequate modeling of these links is important if a complete assessment is to be made. While the actual magnitude of the impact of the policies and shocks considered will likely differ from the precise numerical predictions of the model, the insights provided about the transmission mechanism are important. For example, the results suggest that trade linkages often work in the opposite direction to financial linkages, and that there is often a trade-off between the positive effects from a shock through one channel and the negative effects through the other. Indeed, financial flows act as automatic stabilizers in many of the simulations considered. It also appears to matter whether the trade linkages are for final consumption goods or for intermediate goods to be used in production. The relative importance of each channel determines the overall impact of the policies. The simulation results have a number of implications for the ongoing policy debate in Japan, and for policymakers in other Asian countries as they assess the potential impact of any policy changes in Japan on their own economies. • Trends in Japanese productivity growth have important implications for both the domestic economy and the region. Structural reforms that boost productivity growth over the medium term will provide a boost to growth domestically and in the region (Table 12.3). • As Japan moves toward fiscal consolidation over the medium term, the results give some grounds for optimism that the economic impact can be limited. While there will undoubtedly be a

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Table 12.3. Impact on Real GDP: Summary of Selected Simulation Results (Percent deviation of GDP from baseline) Phased Fiscal Consolidation1 _____________________________

Japan Taiwan Province of China Korea Hong Kong SAR Singapore Thailand Indonesia Malaysia Philippines China

Increase in Monetary Productivity Easing2 Growth3 ____________________ _________________ Impact after:

Loss of Confidence in the Yen4 _________________

1 year

3 years

5 years

1 year

5 years

1 year

5 years

1 year

5 years

0.2

–1.0

0.4

0.4

0.0

1.2

6.3

–0.1

–8.8

0.1 0.1 0.1 0.1 0.0 0.1 –0.1 0.1 0.0

0.6 0.5 0.7 0.5 0.5 0.3 0.6 0.7 0.2

1.1 1.1 1.4 1.2 1.0 0.6 1.3 1.2 0.4

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.1 0.0 0.0 0.0

0.1 0.1 0.1 0.1 0.1 0.1 –0.1 0.1 0.0

1.6 1.3 1.8 1.4 1.5 0.7 2.0 1.9 0.4

0.2 0.2 0.2 0.2 0.1 0.2 –0.3 0.1 –0.1

2.7 3.0 3.7 3.1 2.7 1.5 3.0 2.5 1.0

Copyright © 2003. International Monetary Fund. All rights reserved.

1Reduction in government expenditure of 1.7 percent of GDP in the first year, 3.4 percent in the second year, and 5 percent from the third year onward. 2Bank of Japan purchase of government bonds sufficient to bring about a permanent 1 percent increase in the money supply. 3Increase in growth rate of labor augmenting technical change of 3 percent a year for 3 years, 1 percent a year for another 8 years, and then returning to trend. 4A 3 percentage point increase in the risk premia on all Japanese assets.

negative short-term impact on activity, this could be fairly limited if the announcement were credible—perhaps legislated in a fiscal responsibility act that specified a long-term public debt target and the tax, expenditure, and social security policies to back up that target—and would be quite quickly replaced by the positive impact from the decline in real interest rates and rise in equity prices. The negative short-run impact could also be offset by a more expansionary monetary policy. The existence of financial as well as trade linkages means that the effects of the fiscal consolidation in Japan are broadly neutral for the region in the short-run, but beneficial over the medium term. • The results suggest that a quantitative easing of monetary policy through the Bank of Japan’s outright purchase of government bonds would stimulate the economy in the short run, and from a position of insufficient demand would help close the output gap. However, in the current situation the impact of such a monetary stimulus is highly uncertain, and the results should be taken more as indicating the transmission channels through which a policy relaxation could work, rather than the actual size of the impact it would have.

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• In terms of the exchange rate, an important point that emerges from the results is that the implications of a weakening of the yen depend on the reasons for the depreciation. For example, a depreciation due to a loss of confidence in Japan has a large negative effect on Japan, but could actually be positive for the region because of the increase in capital inflows they would receive. If the depreciation is due to monetary easing, however, this has a positive impact on the Japanese economy, but is broadly neutral for the region because the positive effect on growth in Japan offsets the loss of competitiveness from the yen’s depreciation.

References Bayoumi, Tamim, and Gabrielle Lipworth, 1998, “Japanese Foreign Direct Investment and Regional Trade,” in Structural Change in Japan: Macroeconomic Impact and Policy Challenges, ed. by Bijan Aghevli, Tamim Bayoumi, and Guy Meredith (Washington: International Monetary Fund), pp. 63–94. Callen, Tim, and Warwick J. McKibbin, 2001, “Policies and Prospects in Japan and the Implications for the Asia-Pacific Region,” IMF Working Paper 01/131 (Washington: International Monetary Fund).

Copyright © 2003. International Monetary Fund. All rights reserved.

Kawai, Masahiro, 1998, “Role of FDI for Structural Change in Japan’s Trade Patterns,” comment on Bayoumi and Lipworth in Structural Change in Japan: Macroeconomic Impact and Policy Challenges, ed. by Bijan Aghevli, Tamim Bayoumi, and Guy Meredith (Washington: International Monetary Fund), pp. 97–102. Kohsaka, Akira, 1996, “Interdependence through Capital Flows in Pacific Asia and the Role of Japan,” in Financial Deregulation and Integration in East Asia, ed. by Takatoshi Ito and Anne O. Krueger (Chicago: University of Chicago Press), pp. 107–42. McKibbin, Warwick, 2001, “Documentation of the G-Cubed Asia-Pacific Model— version 46n,” McKibbin Software Group Pty Ltd, Canberra, Australia. Available on the Internet: http://www.msgpl.com.au/msgpl/apgcubed46n/ index.htm. ———, and D. Vines, 2000, “Modeling Reality: The Need for Both Intertemporal Optimization and Stickiness in Models for Policy-Making,” Oxford Review of Economic Policy, Vol. 16 (Winter), pp. 106–137. McKibbin, Warwick, and Peter Wilcoxen, 1998, “The Theoretical and Empirical Structure of the G-Cubed Model,” Economic Modeling, Vol. 16 (January), pp. 123–48. Nakamura, Yaichi, and Izumi Matsuzaki, 1997, “Economic Interdependence: Japan, Asia, and the World,” Journal of Asian Economics, Vol. 8 (Summer), pp. 199–223.

Japan's Lost Decade : Policies for Economic Revival, International Monetary Fund, 2003. ProQuest Ebook Central,

Copyright © 2003. International Monetary Fund. All rights reserved. Japan's Lost Decade : Policies for Economic Revival, International Monetary Fund, 2003. ProQuest Ebook Central,

Copyright © 2003. International Monetary Fund. All rights reserved.

JAPAN’S LOST DECADE Policies for Economic Revival

Japan's Lost Decade : Policies for Economic Revival, International Monetary Fund, 2003. ProQuest Ebook Central,