Summary of discussions:
International Workshop on Monetary and Financial Issues in Japan

April 22, 2002
Department of Information and Research Cooperation
Economic and Social Research Institute

   The following is the Summary of discussions of "international workshop on Monetary and Financial Issues in Japan" in March 20 and 22 where relevant American and Japanese specialists participated. This summary is prepared by Secretariat of the Workshop. (Below titles are omitted from names)
Part 1: Monetary Policy
 
   The following issues were discussed: 1) the causes of deflation (evaluation of Japanese monetary policy in the 1990s), 2) monetary policy under zero lower bound on nominal interest rate (effectiveness of quantitative easing), 3) sufficiency of current quantitative easing, 4) methods of quantitative easing, and 5) the role of expectations in monetary policy.
 
1. The causes of deflation (evaluation of Japanese monetary policy in the 1990s)
 
   Opinions about the causes of deflation were divided into two: Some argued that monetary policy in the 1990s was overly restrictive (Hoshi, McCallum, Meltzer, Ito, Kawai and others). Others emphasized supply side factors (Horiuchi, Yoshikawa, Kaku, and Kosai).
   Hoshi and McCallum argued that short-term interest rate and growth of base money suggest monetary policy was overly restrictive. McCallum showed that if monetary policy had been conducted according to Taylor rule, the growth of base money would have been 11.9% on average (5.4% in actuality) and growth of nominal GDP would have been 3.1% (0.7%). Besides, Meltzer pointed out, that despite the productivity growth in the United States was higher, the exchange rate did not depreciate because the Bank of Japan (BOJ) took sterilization measures, which resulted in domestic price decline.
   On the other hand, Kosai pointed that GDP deflator implying factor prices has dropped the biggest among price indicators and argued that current deflation was affected mainly by adjustment of wages and land prices brought by the globalization and liberalization. He insisted that the labor market of Asian developing countries has not reached the full-employment level, which made the adjustment through exchange rate impossible and, as a result, Japan has no other choice but to reduce prices under the pressure of competition. Yoshikawa said that during great depressions of 19th century increase in base money did not bring a solution to deflation and emphasized low potential GDP growth as the cause.
 
2. Monetary policy under zero lower bound on nominal interest rate (effectiveness of quantitative easing)
 
   Most of participants (Hoshi, McCallum, Meltzer, Ito, Hayashi) agreed that theoretically further quantitative easing would have a positive effect through the depreciation of yen and so forth, although the effectiveness is reducing because the base money increase has smaller effect on money supply (M2+CD). However, Tsutomu Watanabe claimed that interest rate and monetary aggregate are the two sides of a coin and if interest rate has no effect, quantitative easing will not have any effect as well.
   Hoshi said that the relation of MB and M2+CD seems to have gotten weaker, especially, after implementation of zero interest policy, but still exists and insisted that the BOJ should not hesitate to take more aggressive policy if the spillover effect is weak. Meltzer referred to the U.S. experiences in 1937-38 and 1948-49 when short-term interest rate was close to 0%. In both periods, drop in prices led to increase in real interest rate, but at the same time real increase in base money contributed to economic recovery.

(Insufficient lending ability)
   Horiuchi and Kaku stressed that manufacturing industry has excess capital and does not demand new loans. However, many participants argued that monetary policy still works through other channels, although admitting that insufficient lending ability lowered the effectiveness of monetary policy (Meltzer, Hoshi, and Hayashi).

(Worsening solvency of the BOJ)
   Many participants agreed that the recovery of Japanese economy is more important than healthy balance sheet of the BOJ.
   Meltzer argued that this type of argument has been discredited and rejected long ago and that it is the essential responsibility of a central bank to lend or supply liquidity when others will not. He said that no central bank has been unable to act because it had negative equity and also said that because most of the central bank's liabilities bear no interest, the future earnings must eventually offset the loss of wealth from a rise in interest rate. Hayashi sees no problems if the balance sheet of the BOJ is valued at market prices.
   On the other hand, Shiratsuka said that present BOJ Law does not state the case when the BOJ falls in excessive liabilities and argued that it is necessary to reach a national consensus concerning worsening of the balance sheet of the BOJ. He also insisted that government should commit more clearly to the problem.

(Beggar-thy-neighbor policy through devaluation of yen)
   Yoshikawa pointed that impacts of yen depreciation brought by base money increase should be examined from international perspective and argued that such a policy needs to obtain the agreement of the United States.
   McCallum and Meltzer pointed out that yen depreciation would not constitute a beggar-thy-neighbor policy because the income effects would tend to increase imports. They said that it is important to explain this to the neighboring countries.
 

3. Sufficiency of current quantitative easing
 
   In March 2001, the BOJ took the course of quantitative easing, and especially after September the growth of base money is accelerating. Kaku said that these measures are excessive. Shiratsuka doubted whether further quantitative easing would be effective. However, many other participants appreciated the policy change. McCallum, Sheard, Kawai and Hoshi stated that further easing is necessary.
 
4. Methods of quantitative easing
 
   A lot of the participants admitted that non-standard open market buying operations, in which the central bank buys assets other than short-term government bonds, are necessary. However, participants did not come to a consensus what assets the BOJ should buy.
   McCallum and others insisted on purchasing foreign exchange because long-term government bonds are also close substitute for base money. Regarding the critics that the BOJ has no legal authority to purchase foreign exchange, he stated that the BOJ could overcome it by requesting approval from the government (Ministry of Finance) for the time being.
   On the other hand, Ito said that buying foreign exchange would be ineffective if the United States took the counter intervention and insisted on buying long-term government bonds, CP, CB, investment trust securities and REIT (Real Estate Investment Trust), if necessary.
   Kawai agreed with him and stressed the importance of international policy consistency (McCallum argued against it and noted that no other country except Japan faced with the problem of zero lower bound on nominal interest rate). He stressed the risk that buying operation on foreign exchange market prompts crush of yen and insisted on leaving exchange rate to its market movement.
   Besides these measures, Hoshi suggested that money transfers to households such as a helicopter drop of money would also work. Meltzer said that purchase of non-performing loans by the BOJ is worthy of consideration. Sheard noted that purchase of bonds issued by the Resolution and Collection Corporation deserves some consideration.
 
5. The role of expectations in monetary policy
 
   Many participants admitted that expectations play the important role in monetary policy and stressed that it is crucial for the BOJ to enhance its commitment and thus dialogue with market participants.
   McCallum, Kashyap and Hayashi blamed the BOJ for having always said that nothing more could be done. Meltzer said that explanations of the BOJ were very ambiguous as if they said, "Do not believe our policy".
   To the contrary, Shiratsuka said that although the BOJ's commitment was successful as the measure to stabilize financial system, its stimulating effect was small.

(Inflation targeting policy)
   Participants did not reach a consensus concerning inflation targeting policy.
   McCallum, Meltzer, Ito, Tsutomu Watanabe, Kawai, Hamada and Hoshi advocated adopting inflation-targeting policy.
   Tsutomu Watanabe and Sheard criticized the committed level in the announcement of the BOJ in March 2001 that "the new procedure will continue to be in place until CPI register stably a 0% or an increase year on year" is too low. Watanabe said the BOJ should commit higher level such as 3-4%. Iwata said that CPI of 0% or higher is a terminal condition to stop current monetary easing policy, but, if we talk about inflation targeting, it should be higher.
   To the contrary, Shiratsuka stressed the necessity to distinguish between long-term policy and emergency reflation policy and argued as follows. The policy is important to secure transparency of long-term monetary policy management. But if the policy is taken as emergency measure, it is no more than a gamble. The argument of inflation targeting policy is the same with the argument whether more aggressive policy should be taken to cease the deflation.
   Besides, Yoshikawa, Kaku, Horiuchi cast skepticism on successful adoption of inflation targeting policy saying that the transmission mechanism that the adoption raises the inflation expectations is ambiguous. However, Yoshikawa said that he would not care the adoption if the policy were accompanied by other policies.
 

Part 2: Non-performing Loan (NPL) Problems
 
   The following points were discussed: 1) the evolvement of the NPL problems, 2) future strategy to resolve the NPL problems, 3) development of robust financial system, 4) necessity to inject public funds at the present moment, 5) methods of public fund injections.
 
1. The evolvement of the NPL problems
 
   Regarding reasons of 9.7% increase in the NPLs during the last half a year, 1) delays in disposing the NPLs, 2) emergence of new NPLs due to deflation, 3) tighter asset appraisals were pointed out (Takashi Watanabe).
   Kanda (only paper's presentation) identified the factors behind prolonged NPL problems as 1) Bank managers have incentives to continue bad lending and not to dispose NPLs and 2) government does not have enough information to take necessary measures for disposal. Besides, Sheard said that the government tried to harmonize two opposite policies: to prevent financial crisis and to minimize public fund injections. He also pointed out that the BOJ and the government has been trapped in political gridlock: While the BOJ insists that they cannot stop deflation until dissolution of NPL problems, the government says that they cannot solve the NPL problems until end of deflation.
   Concerning the stricter asset appraisal, Takashi Watanabe expressed some appreciation that the Financial Services Agency (FSA) gradually started to face up to reality and the strict asset appraisal done by some city bank was gradually followed by others. But he added those movements were very slow and criticized that lenient reconstruction plans turned healthy loans into the NPLs.
   Nevertheless, some progress has already been made in resolving the NPL problems, namely, 1) progress in buying NPLs at market prices (Kawai), 2) mergers of major banks (Kawai), and 3) progress in restructuring taking the forms of failures of big companies in distribution and construction industry (Kawai, Watanabe and others).
 
2. The future strategy to resolve the NPL problems
 
   Kroszner described the experience of the United States and Nordic countries during banking crises. He stated that policy makers' underestimate of the size of the banking problem led to delay and inadequate policy responses. Eventually, recognition of the seriousness of the problem led to more aggressive or definitive policy actions that ended in successful solutions. With regard to Japan, he raised the question of whether measures taken in 1998 can be identified as the start of a definitive policy response or not.
   Many participants reached the consensus that delays in addressing NPL problems raise eventual disposal costs - definitive measures by the government and private institutions are absolutely crucial for the resolution of NPL problems.
   Kroszner noted that in other countries definitive policy actions on NPLs, taken together with monetary easing, did not have a negative effect on the economic climate. He showed that in the United States, auctions following definitive policy measures did not depress, but in fact increased asset prices. He drew attention to the fact that recent failures of big companies in Japan, resulting from banks refusing to provide funding, were seen as positive developments that raised overall stock price.

(Importance of government leadership)
   While Sheard attached weight to removal of blanket guarantee on deposit, Hoshi, Kashyap and others emphasized the importance of government leadership. Sheard and Kashyap said that government should provide sufficient financial resources to resolve the NPL problems. Sheard added that support of the BOJ is also important. Kashyap said that the government does not have enough resources and staff supervising banks and insisted that it is necessary to increase the budget of the FSA.

(Watering of capital adequacy ratio of banks)
   Capital adequacy ratio of banks is padded by deferred tax assets and injected public funds (Kashyap, Okina, Iwata). Hoshi and Kashyap anticipated that major banks pretend to have "healthy" capital adequacy ratio of more than 10%, when the results of special inspection are revealed.
   As opposed to that, Ueda said that exclusion of deferred tax assets from the definition of capital adequacy ratio is a deviation from the present accounting rules set by the FSA. He argued that it is doubtful whether we can accuse the bank top managers by using the altered rule.

(Resolution and Collection Corporation)
   It is important for RCC to sell NPLs in the market. It is also necessary to provide incentive mechanism for disposal of NPLs through market sales (Hamada, Kashyap, Hoshi). There is fear that purchase of NPLs at high price by Resolution and Collection Corporation (RCC) may discourage development of the NPL market (Hoshi).
   RTC in the United States played the important role in reconstruction as well as in disposal (Kroszner). In North European countries, market appreciated restructuring of failed companies and injected public funds were fully collected through the sales of the stocks (Okina).
 

3. Development of robust financial system
 
   Constitutional low profitability of banks is fundamental cause for NPL problems. It is indispensable to improve the business environment so that banks can afford to raise the profits (majority).
   Full guarantee of the deposits contributes to over-banking (Sheard). Government-sponsored public financial institutions reduce competitiveness of private banks. Thus the institutions that contribute to worsening of the NPL problems have to be shut down (Kashyap).

(Corporate governance of banks)
   Regarding over-banking problems, we should distinguish between problem of excessively large number of banks and problem of excessively small capital. The latter cannot be solved by mergers and must be treated as the problem of corporate governance (Sheard).
   Ueda stressed the importance of recapitalization through enhancing its profitability or its restructuring. Kashyap and others suggested that bank managers incapable to raise profitability must be removed.

(Constitutional low profitability of borrowers)
   Behind the low profitability of banks, there are problems of low profitability of borrowers. These companies need to be restructured, to change management executives, or to be liquidated (Kosai, Okina, Kashyap and Hayashi). Preserving money-losing (zombie) companies impairs new entry to the industry, as new comers are reluctant to compete with such subsidized companies (Kashyap).
   Political pressures to keep afloat small and medium-sized companies as "good faith borrowers" are problematic (Kanda's paper). Previous injection of public funds had a problem because accompanied obligation of lending to small and medium-sized companies hindered the improvement of profitability of injected banks (Hoshi, Kaku and Okina).
   Besides, the problems of banking sector are connected with the problem of insurance industry through stockholdings. It is necessary to pursue their simultaneous solutions (Kashyap).
 

4. Necessity to inject public funds at the present moment
 
   Substantial amount of public funds needs to be injected to remove the blanket guarantee on deposits without pushing the economy into a banking crisis (Sheard). It is necessary to accelerate recapitalization of banks, although present banking problems are not so serious as that in 1997 (Kawai).
   On the other hand, "Compulsory injection under present situation needs amendment to present legal framework. The first priority must be to encourage recapitalization of banks through continuing special inspection of the banks". "Under the current situation of distrust to the banks, massive public fund injections are unlikely to be effective. It would rather provide banks the incentive to update their business model". "Using RCC aggressively to distinguish between good banks and bad banks, is worthy of consideration" (Horiuchi). Under the present situation where banks are dumping huge deficit, public funds injection must be done cautiously not to prolong the life of money-losing banks and create moral hazard (Takashi Watanabe).
 
5. Methods of public fund injections
 
   In case of public fund injection, reconstruction incentives of the banks must be highly considered. No more across the board injections should be adopted (all the participants).

(Selective injection of funds before insolvency)
   In addition to injection of funds after insolvency to prevent system risk, it is necessary to inject funds selectively to viable banks that are expected to remain in competition (Okina). Rigorous Asset assessment and reserve allowance must be done to choose the viable bank (Takashi Watanabe). These cases are not assumed in the existing Deposit Insurance Act, so it is necessary to make amendments to the law as early as possible (Takashi Watanabe, Okina).
   To the contrary, public funds injection could be justified under the banking crisis because the crisis is market failure. But enhancing the viability of particular banks is not the issue of market failure. Thus this problem needs more detailed discussion (Ueda).

(Pursue of management responsibility and others)
   The previous injection of public funds under the "Prompt Corrective Action" had the nature to ease the reluctance of healthy banks to lend. Thus 1) Responsibilities of stockholders could not be pursued because of the premise of healthy banks. 2) It was equity capital but had aspects of liabilities, hence, could not be used for write-offs of NPLs. The obligation of dividend-paying rather weakened vitality of the banks (Okina).
   The condition of new selective injection should be complete regeneration of bank management so that banks can make enough profits for their risk taking activities. The successful regeneration shall be done by outgoing of the top management, stricter restructuring and pursuing of the responsibility of stockholders through capital reduction (Takashi Watanabe, Okina, and Kashyap).

(Methods of selection)
   Many participants agreed that much attention should be paid to market signals in choosing viable banks.
   Capital adequacy ratio is a useful measuring stick, but the quality of the equity capital is problematic. So it is necessary to disclose the results of special inspection and to study whether the bank would be viable internationally by observing the market response to it (Okina).
 

Part 3: Policy coordination and other policies
 
   Many participants admitted that there are two-way casual relations between the deflation problems and the NPL problems and stressed the importance of policy coordination consisting of government-initiated structural reforms including the NPLs resolution and the BOJ-initiated monetary easing.
   Regarding other policies, fiscal policy is necessary to stimulate aggregate demand in the short-term (Okina). As opposed to this opinion, fiscal stimulus will only have adverse effect of keeping afloat non-profitable companies (Takashi Watanabe). To contain further increase of budgetary deficit must be already a consensus of opinion. Yoshikawa proposed to promote demand-creating innovations. Japan needs to review fiscal expenditure composition and tax system so that aggregate demand will be stimulated without increasing budget deficit (Ito, Kawai).
 
<Reference>
   McCallum and Kashyap presented their proposal to build a consensus of this workshop. Participants mostly showed favorable response to their proposals. But going into detail, there were some objections. Their proposals were as follows.

McCallum's proposal
   Adopt inflation targeting, with a target of 1-2%, measured by some specified index, and implemented by purchase of foreign exchange or other non-standard assets.
   There should be no target for the exchange rate; it should be free to go wherever is implied.
   The only coordination necessary is for the MOF (Ministry of Finance) and the BOJ (Bank of Japan) Law not to interfere with this policy.

Kashyap's proposal
   The Government should provide sufficient Capital to fully resolve the NPL (Non-Performing Loan) problem.
   Market signals should be used in allocating the funds.
   Government sponsored agencies that contribute to the problems should be closed.
   Bank management should be replaced.
   Money losing firms should be cut off from further funding.
   The Bank of Japan should support this change.
   The FSA (Financial Services Agency) budget should grow substantially.
   Disposing of bad loans through market sales is critical.