Japan and the IMF
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Global Prospects after September 11 and
Mr. Chairman, Ladies and Gentlemen:
It is an honor for me to come to New York at this time—a city that has been through so much in recent months. Without doubt, the citizens of New York have suffered the most serious consequences of the attacks. But in my work for a global economic institution such as the Fund, I am also reminded daily of the effects on ordinary peoples' lives around the world.
I would like to thank you for giving me the opportunity to speak to you about some of these global effects today, and for sharing with you my views about Japan. It is clear that Japan has an extremely important role to play as an engine of world economic growth. But its long economic slump has prevented this from happening. During the course of this speech, I would like to offer my perspectives on the policy steps that Japan should take if it is to return to sustain growth and resume its place in the world economy. Among the areas I will touch on are banking and corporate sector reform; the task of medium-term fiscal consolidation; and monetary policies to address the deflation problem.
II. The Global Outlook
Let me begin by looking at the situation of the world economy today.
The events of September 11 made an already very difficult global economic situation worse. The slowdown that began most prominently in the United States had, by mid-2001, become a synchronized downturn across almost all major regions of the world. This synchronicity was the result of common shocks, such as the bursting of the IT bubble, but increased international linkages in the financial and corporate sectors also played a role. To some extent, the global downturn also reflects the lack of progress with structural reforms in Japan and the euro area that have prevented these countries from taking up the slack when the long expansion in the United States came to an end.
Just prior to the attacks, there appeared a reasonable likelihood of recovery in late 2001, but prospects for global growth have since been set back significantly. As a result of the deeper and more prolonged global slowdown that is now envisaged, the Fund has reduced its projection for world growth this year by one percentage point, to 2.4 percent, the lowest since 1993.
What have been the main channels through which last September's events have worked their way through the global economy?
The direct impact includes of course the tragic loss of life and property, as well as longer-term disruptions to specific sectors, notably the global airline industry and related services. At the macroeconomic level, we have observed sharp reactions in three major areas, namely in consumer and investor confidence, financial markets, and commodity prices.
Although some of these effects are likely to prove temporary, as anticipated by the general strengthening of equity markets since their September lows, it remains difficult to judge how quickly confidence will rebound and how international financial market conditions will develop. Nevertheless, the expectation is that recovery in the global economy should become more evident over the next several months, underpinned by stimulative macroeconomic policies implemented in a number of countries especially since September, completion of the inventory correction, and lower energy prices. The key uncertainties relate to the timing of a rebound in confidence, the future course of corporate earnings and investment, and the possibility that still-richly valued equity markets could see a substantial correction. As far as the emerging markets are concerned, one positive element is that spillover effects from developments in Argentina have been quite limited.
Thus, to sum up, while the expectation is for the global recovery to gather pace in the course of this year and next, there remains a risk of a worse outcome. Policymakers around the globe will therefore need to remain vigilant, and stand ready to act flexibly should the recovery not gather momentum as expected. The stronger macroeconomic fundamentals in most regions—including lower inflation, generally improved fiscal positions, and more flexible exchange rates—increase the room for policy maneuver and economies' resilience to external shocks, and should thereby help to keep the global recovery on track. To make the recovery more robust and sustainable, however, structural fundamentals-including in the advanced countries—need to be strengthened through more vigorous reforms.
III. Short-Term Economic Outlook for Japan
That applies first and foremost to Japan, and let me now turn to a discussion of the economic situation, outlook, and policy requirements in Japan.
Japan is now in its third, and likely deepest, recession in a decade. Insofar as the September 11 attacks have postponed the timing of the global recovery, they have also affected growth prospects for Japan, and there are of course the effects on confidence and financial markets which I mentioned earlier.
My expectation is that the economy will continue to contract in the early part of this year, before experiencing a modest recovery as the global rebound gathers momentum. Leading indicators of business investment suggest that capital spending will decline in the first half of 2002. Household spending is also likely to remain weak given the severe state of the labor market, where unemployment has reached an all-time high. While public investment should support activity in the first half of the year (reflecting the effect of the second supplementary budget), this will fall off after midyear. For 2002 as a whole, the Fund is projecting a further decline in real GDP of 1 percent, with deflation likely to intensify.
Let me emphasize that this outlook has much more to do with fundamental structural weaknesses in the Japanese economy than with the events of September 11. Indeed, the roots of Japan's recurring recessions over the past decade are basically structural in nature. The lackluster performance reflects not only the failure to unwind the excess stocks of capital and debt from the bubble years, but also the slow adjustment to the forces of globalization and technical change, as Japan has lagged in shifting to innovation and productivity—rather than investment and exports—as the engines of growth. The failure to embrace a regulatory regime capable of freeing resource allocation and spurring innovation has also contributed.
IV. How To Restart Sustained Growth In Japan?
For some time now, there has been a debate about how to get recovery started in Japan. Some emphasize a deficiency of demand as the problem, and hence argue for aggressive macro-policy stimulus. Others stress that structural problems in the bank and corporate sectors need to be resolved if self-sustaining growth is to be restored. Personally, I do not find this distinction particularly helpful. Rather, I believe that the only viable strategy for Japan is to move forcefully ahead with bank and corporate restructuring in the context of a macroeconomic policy that is as supportive as possible. I say this is the only viable strategy because policies aimed solely at boosting demand have been tried for at least a decade in Japan, and have so far failed to ignite strong, sustainable growth. On the other hand, vigorous economic restructuring could well intensify recessionary pressures in the economy in the short run. To maintain political support for needed restructuring, and ease the economic pain that it could engender, a supportive macroeconomic policy framework is essential.
Let me first turn to the critical banking and corporate sector issues that are at the heart of Japan's economic malaise, before discussing macroeconomic policy issues.
No country can grow for an extended period of time without a healthy and profitable banking system. Unfortunately, Japanese banks fulfill neither criteria at present. Despite more than 70 trillion yen in loan write-offs since the bursting of the bubble (equivalent to twelve percent of annual GDP), nonperforming loans continue to account for more than 6 percent of outstanding bank loans, and probably more if the large amount of loans to weak corporate borrowers is taken into account. At the same time, coping with loan losses has become more difficult as banks' operating profits have deteriorated, in part because of their concentration on low margin loans to large corporate borrowers. As a result, the average return on bank equity has been below three percent for most of the past decade, compared to double-digit returns for most large banks in the U.S. and Europe.
Decisively addressing the problems in the banking sector is absolutely a top priority. There still remains considerable uncertainty about the size of the bad loan problem and the adequacy of banks' provisions against these loans. The Financial Services Agency's (FSA) ongoing special inspections of the major banks should help to shed light on this issue, but until the scale of the problem is fully recognized, a final resolution will remain elusive.
If a thorough assessment of banks' asset quality were to lead to a much larger scale of nonperforming loans, the necessary additional provisions would, of course, adversely impact bank capital. In some cases, losses could even exceed banks' own reserves and their capacity to raise additional funds from the markets. Public capital injections targeted at weak but viable institutions may thus be necessary to strengthen bank balance sheets and maintain systemic confidence, particularly in view of the impending reintroduction of partial deposit insurance. The FSA also needs to intervene promptly in the case of unviable banks, including through the purchase and assumption method or temporary nationalizations where necessary.
While public capital could be important in ensuring short-term financial stability, it would not by itself lead to an improvement in underlying bank profitability. Therefore, capital injections should be based on strong conditionality—involving management changes and participation in debt workouts—if they are to advance genuine restructuring and limit moral hazard. In this context, another delay in the return to partial deposit insurance would be counterproductive as it would again ease pressure on banks to restructure. To widen the scope for profitable lending opportunities, the role of public sector financial institutions, in particular the postal savings system, needs to be pruned. Critical also is a stronger role for private shareholders in holding bank management accountable, which underscores the need to ensure that banks are fully included in ongoing efforts to strengthen corporate governance.
Let me briefly refer to Japan's welcome decision to participate in the Fund's Financial Sector Assessment Program, or FSAP. This has led to some public misunderstanding as to whether the Fund would now become engaged in individual bank inspections. I would like to explain that the FSAP is solely intended to give our member countries an impartial outside perspective on their financial system as a whole. An FSAP involves an evaluation of a country's regulatory and supervisory structures relative to best practices and internationally accepted standards and codes. The program also includes a financial sector stability assessment, but this does not involve inspections of individual financial institutions, which remain firmly in the purview of the domestic bank regulator.
Excess leverage in Japan's corporate sector is of course the counterpart of the massive burden of problem bank loans, given the pre-eminent role of banks in corporate finance in Japan. A key payoff that I see from accelerating the process of banks' bad loan disposal is thus not only to restore health to the banking system and allow banks to again perform their intermediation function successfully, but also to encourage restructuring in the real economy, and inevitably, the prompt exit of nonviable companies.
What can be done to accelerate the process of corporate restructuring? Financial institutions will necessarily have a key role to play in pushing debtors to institute credible plans to restore their financial condition over the next couple of years. To do this, they should make full use of the recently-agreed private-sector guidelines on out-of-court debt workouts and the streamlined corporate reorganization procedures. They may also choose to sell problem assets to the Resolution and Collection Corporation (RCC), whose mandate in acquiring bad loans and overseeing corporate rehabilitations has recently been expanded.
Although the private sector has taken on an increasingly important role in resolving troubled assets, a liquid market for bad loans has not yet developed in Japan. This is in part because secondary market prices include a substantial premium as long as reorganization and collection procedures are evolving. The RCC could fill an important gap here, by applying its experience in loan collection to a wider array of loans, and by acquiring the necessary restructuring expertise while cooperating closely with dedicated private sector funds. However, it will be important to ensure that the RCC is allowed to pay competitive prices, which raises the possibility that it may incur losses on some of the loans it has acquired.
As this audience knows very well, fiscal policy efforts to lift Japan's economy out of recessions over the past decade have left the public sector with very high deficits and debts, both in absolute terms and relative to other major industrial countries. Restoring soundness to Japan's public finances will be an immense challenge for policy makers—and one that will take many years to resolve. But it has to be done, and here I would like to express my strong support for PM Koizumi's determination to meet that challenge over the medium term.
However, I doubt there is a case for a contractionary fiscal policy in 2002, when we are almost certain that real GDP will shrink for the second year in a row. And I am afraid that the fiscal policy course now in train will impart a significantly contractionary impulse to the economy, particularly later in the year when the impact of the second supplementary budget fades. My recommendation is for a more neutral fiscal policy in the near term. This will require the authorities to continue to respond flexibly to evolving economic conditions, and will likely call for a fiscal package later in the year, focused as far as possible on measures to encourage economic restructuring, rather than on low-quality public works.
At the same time, it is critical for the government to press ahead with reforms that anchor its commitment to medium-term fiscal consolidation. On the tax side, the introduction of taxpayer identification numbers would improve tax administration and facilitate the much-needed broadening of the personal income tax base, while the further de-earmarking of road-related tax revenues could greatly improve the quality of fiscal spending. A reorientation of the tax system—from direct toward indirect taxation—could also contribute to reducing the distortions from the present over-reliance on a relatively small set of corporate and salaried incomes. There is also much potential to address excessive public works spending in Japan, and to reorient a portion of the savings to strengthen the social safety net and improve retraining programs, in order to ease the pain for dislocated workers and facilitate economic restructuring. With regard to social security, more far-reaching reforms are needed to improve confidence in the system and address the pressures from population ageing.
On monetary policy, let me begin by welcoming recent actions by the Bank of Japan to raise its policy target for deposits held at the central bank several times in response to the worsening outlook, and to provide liquidity in excess of the target when needed to meet the extraordinary and volatile demand for funds since September. Nevertheless, Japan's consumer price index has now been falling on an annual basis for 2½ years, and the recent actions by the BoJ are unlikely to turn this situation around in the near term.
What is the way forward? I will not be the first person to note that monetary policy in Japan is to some extent now operating in uncharted territory, with short-term interest rates at their floor, and the effectiveness of a key transmission channel for monetary policy hampered by weaknesses in commercial banks' balance sheets. But I do not conclude from this that the Bank of Japan has no further means to address the deflation problem. My own view is that further efforts to expand base money should be pursued, within a framework in which the Bank of Japan publicly commits to end deflation within a specific timeframe (say, one year). Indeed, beyond the one-year horizon, a strong case can be made for aiming for a positive rate of inflation—perhaps 2-3 percent—to reduce risks that Japan could once again find itself constrained by the zero bound on nominal interest rates.
It is possible that the economic strategy I have recommended—involving a forceful push for bank and corporate restructuring within the context of a supportive macroeconomic policy—could result in a weak yen in the short term (although as the vigor of Japan's economy is restored, longer-term upward pressures on the yen could resume). A key issue is the regional and multilateral impact that this would have. My own perspective is that the impact will be better tolerated in the context of full implementation of an integrated policy package that lays the foundation for healthy medium-term growth, rather than as the result of monetary policy easing alone. After all, one should not underestimate the benefit for trade and growth in the Asian region—and indeed the world—of a vigorous Japanese economy. I would also note that the potential adverse effect of a weak yen is likely to be less now than it was a few years ago, given the greater flexibility of exchange rates in the region. To sum up, while concerns about the yen should not in my view undercut the BoJ's efforts to bring deflation to an end, it is even more critical that monetary policy actions take place as part of a strong package to reinvigorate Japan's economy.
Let me conclude by noting that, while the challenges ahead are significant, further delays in implementing the difficult structural reforms that I have discussed could prove very costly—raising the risks of financial instability and prolonging the period of economic malaise. The government of Prime Minister Koizumi must make full use of its very high public approval rating to push through the reforms that are needed to reinvigorate the bank and corporate sectors, while the Bank of Japan needs to use all the instruments at its disposal to bring deflation to an end in a timely way. I for one believe that such efforts will be well rewarded—and are fully capable of restoring Japan's economic potential and allowing it once again to play a key role in fostering world prosperity.
IMF EXTERNAL RELATIONS DEPARTMENT