## _wp09282

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---

### Introduction — global outlook and framing
- Recent economic news shows tentative improvement after two quarters of sharp decline, led by a “sharp rebound in Asia” and stabilization/modest recoveries elsewhere; market panic has “receded significantly,” but stresses remain.
- Key policy and analytical questions highlighted:
  - Are current “green shoots” durable or “false dawns”?
  - What signs indicate a sustainable recovery?
  - How vital is balance-sheet repair for creditors and debtors, and how can it be achieved?
  - How should fiscal and monetary policy support growth while balance-sheet repair proceeds?
  - How should exit strategies be designed and communicated?
  - What are potential longer-term legacies for growth, inflation, and public debt?

### Japan’s lost decade — phases, dynamics, and pivot points
- Three-phase chronology:
  - Phase 1 (1990–97): Crisis outbreak and fragile recovery.
  - Phase 2 (1997–2000): Systemic stress after the Asian financial crisis and a second recovery attempt.
  - Phase 3 (2001–03): Renewed stress from the IT bubble collapse followed by sustained recovery once financial and corporate restructuring advanced.
- Key facts and metrics:
  - Asset bubbles in stocks and real estate collapsed in 1989–1990 after having “tripled during the latter half of the 1980s.”
  - Pre-crisis expansion: “almost 4 percent annually” for two decades after 1973 (OECD average “around 2¾ percent”).
  - Early post-bubble growth averaged “1½ percent between 1991 and 1994.”
  - Unemployment rose; inflation fell “from highs of around 3½ percent.”
  - By 2002, unemployment reached “a post-war high of 5½ percent.”
  - NPL ratios peaked at “almost 9 percent.”
  - Public net debt rose to “nearly 75 percent of GDP.”
  - From 2003 to 2007 growth averaged “2 percent”; net exports accounted for “around a third of Japan’s growth” in that period.
- Turning point conditions:
  - Durable recovery required aggressive recognition and disposal of NPLs, bank recapitalization, corporate deleveraging (corporate debt fell from “120 percent” of GDP in 1995 back toward prebubble levels by 2004), and favorable external demand.

### Financial- and corporate-sector interventions — strategy, scale, and outcomes
- Emphasis on financial-sector repair:
  - Bank losses exceeded “¥100 trillion”; public funds of “around ¥47 trillion” were used to dispose of NPLs and recapitalize banks.
  - Nearly “three-fourths” of the public funds used in financial interventions have been recovered to date.
- Public funds and conditionality:
  - Early capital injections had “relatively few conditions” and did not resolve the NPL problem.
  - Effective approach combined realistic asset valuation, accelerated NPL disposals, stricter conditions on capital injections, and close FSA monitoring under agreed reorganization plans.
- Centralized asset management and NPL resolution:
  - IRCJ and RCC purchased and disposed of distressed assets, aided price discovery, and clarified creditor claims; IRCJ generated “a small profit before shutting down in 2007.”
- Private-sector restructuring and insolvency reforms:
  - Large write-offs and debt restructuring by banks plus insolvency reforms and out-of-court workouts were instrumental in corporate deleveraging.
  - Deferred tax assets in 2003 “accounted for nearly one-half of Tier-1 capital in major banks,” prompting limits on their use for regulatory capital.

### Liquidity provision, monetary policy, and unconventional measures
- Liquidity and credit constraints:
  - Exceptional liquidity provision forestalled immediate systemic collapse but, without loss recognition and capital repairs, banks could not extend new credit.
  - Regulatory forbearance and weak incentives limited equity issuance and loan write-downs, maintaining credit bottlenecks.
- BoJ policy actions and numeric facts:
  - ZIRP: policy rate lowered to “0.15 percent” then to “as low as 0.02 percent” (February 1999).
  - Quantitative easing from March 2001 tied to banks’ current account balances; BoJ purchases of long-term government bonds rose from “¥400 billion to ¥1.2 trillion per month.”
  - BoJ balance sheet rose from “¥91 trillion (18 percent of GDP) in 1998” to “about ¥155 trillion (31 percent of GDP) in 2006.”
  - BoJ purchases of equities during 2002–04 reached “¥2.1 trillion ($18 billion),” about “6 percent of banks’ total equity holdings.”
  - BoJ balance-sheet shrinkage (March–July 2006) fell from “¥145 trillion to ¥116” reflecting a “¥20 trillion decrease in funds supplying operations.”
- Impacts and limits of unconventional measures:
  - Quantitative easing and liquidity measures helped reduce interbank risk premia and supported corporate lending marginally, but did not immediately arrest deflation or revive bank credit due to weak bank and corporate balance sheets.
  - Side effects included a “sharp decrease in the money multiplier,” reduced market activity, compressed credit spreads and bank profits, and weakened incentives for restructuring.

### Fiscal policy — scale, composition, and constraints
- Fiscal support magnitudes:
  - Government injected public funds of “nearly ¥47 trillion (10 percent of 2002 GDP)” to recapitalize banks and deal with problem loans.
  - Stimulus headline total: “¥140 trillion”; actual spending about “¥40 trillion (8 percent of 2000 GDP).”
  - Guarantees reached “nearly ¥30 trillion (6 percent of GDP) by 2001.”
  - Tax measures: tax cut “about ¥5.5 trillion (1.1 percent of GDP)” in 1994; consumption tax increase raised burden by “some ¥7.0 trillion (1.4 percent of GDP)” in 1997; temporary income tax cut “about ¥4.0 trillion” in 1998 and another cut of “¥6.6 trillion” in 1999.
- Effectiveness and constraints:
  - Average deficits “more than 5 percent of GDP between 1993 and 2000” contributed to net debt rising to “60 percent of GDP.”
  - Cyclically adjusted deficit widened more substantially after 1998.
  - Estimates of fiscal multipliers “range 0.4–2.0”; Cabinet Office estimated public investment multiplier fell from “1.3 in 1991” to “1.1 in 2004.”
  - Implementation frictions: land purchases and local matching-fund shortfalls left about “15 percent of budgeted public investment unused”; early stop-start stimulus (including the 1997 consumption tax increase) undercut demand.
- Long-term fiscal legacies:
  - Net public debt quintupled by mid-2001 amid weak growth and stagnant revenues.
  - Gross public debt approached “200 percent of GDP,” constraining policy despite low long-term yields.

### Exit strategies — monetary and financial unwinding
- Monetary exit (BoJ experience):
  - October 2003: BoJ tied exit conditions to core CPI being nonnegative for a few months and forecasted positive by a majority of Policy Board members.
  - March 2006: BoJ announced gradual liquidity drainage while keeping overnight rates effectively at zero; by July 2006 transition to a more normal framework occurred with policy rate increases.
  - BoJ shrank its balance sheet without selling JGBs and met its “banknote rule” as money demand recovered.
- Financial-sector and fiscal exit challenges:
  - Unwinding public-sector interventions was lengthier and more complex: replacing blanket guarantees with partial deposit insurance, gradual repayment of public funds, and divestment of public equity took time.
  - Nearly “three-fourths of the 10 percent of GDP in public funds” used for bank recapitalization/NPL disposal have been recouped; “10.4 trillion yen is covered by the taxpayers, with the remaining amount scheduled to be covered by deposit insurance fees.”
  - Withdrawal of SME support and other guarantees proceeded gradually, possibly delaying needed restructuring.
- Trade-offs:
  - Policymakers faced the dilemma of keeping stimulus long enough to prevent deflation but not so long as to create new distortions or unsustainable debt dynamics.
  - Clear articulation of exit conditions and medium-term fiscal consolidation plans helped markets and political economy—but were difficult to implement rapidly.

### Structural legacies and long-run implications
- Persistent scarring:
  - Average growth fell to “half” the 4 percent rate of the 1980s.
  - Gross fixed capital formation was “more than 5 percent of GDP lower” on average compared to the 1980s.
  - Asset prices remained depressed: stock market “some 40 percent below its precrisis high”; house prices “some 70 percent below their precrisis high.”
  - Headline inflation only “edged into positive territory from 2006”; policy rates peaked at “a mere 50 basis points.”
- Policy and reform imperatives:
  - Lasting recovery requires cleaning up bank and corporate balance sheets, stronger supervision, insolvency and accounting reforms, and private-sector-led restructuring.
  - Structural reforms and global rebalancing are likely necessary to restore productivity and long-term growth.

### Lessons and policy recommendations drawn from Japan’s experience
- Core lessons:
  - “Green shoots are not a guarantee of recovery”; durable recoveries require coherent improvements across trade, financial conditions, and private domestic demand.
  - Early and full recognition of bank losses and capital shortfalls jump-starts restructuring and supports sustained recovery.
  - Public funds can be effective if conditioned on writedowns, asset-disposal plans, and governance reforms; realistic asset valuation and centralized asset-management entities accelerate clean-up and price discovery.
  - Unconventional monetary measures can buy time but are no substitute for balance-sheet repair and carry increasing side effects the longer they persist.
  - Clear medium-term exit and consolidation strategies can help manage market expectations and address long-run fiscal legacies.
- Specific policy recommendations:
  - Conduct rigorous inspection of asset quality (e.g., discounted cash flow valuation, mark-to-market accounting, cross-bank cross-checks) and regular stress-testing.
  - Use centralized asset management vehicles with clear mandates to buy distressed assets, promote price discovery, and resolve credit disputes.
  - Tie public recapitalization to strict conditions: equity writedowns, management change, reorganization plans, and accelerated NPL disposals.
  - Target fiscal stimulus toward high-multiplier projects and transfers to households with high marginal propensity to consume; prioritize measures that revitalize private credit channels.
  - Consider temporary, transparent coordination between monetary and fiscal authorities for limited government bond or private debt purchases where market dysfunction threatens transmission—while protecting central bank independence and managing credit risk (Treasury agencies may be preferable operators when credit risk is significant).
  - Develop and communicate concrete medium-term fiscal consolidation and exit plans early to limit Ricardian effects and maintain credibility.
  - Pursue insolvency, accounting, and governance reforms to enable private-sector-led restructuring and attract private capital to rehabilitate viable firms.

*Source: _wp09282 - IMF working paper excerpts supplied.*

### Introduction ...........................................................................................................

### Introduction

### Global outlook and core questions
- Following two quarters of free fall, recent economic news provides grounds for cautious optimism: a sharp rebound in Asia together with stabilization or modest recoveries in other regions suggest the world economy seems to slowly be returning to life.
- Panic in global financial markets has receded significantly, although stresses remain; green shoots are sprouting across the world, raising hopes that the end of the “Great Recession” is in sight.
- Key questions posed:
  - Are current green shoots harbingers of a true turning point or “false dawns” propped up by stimulus and other temporary factors?
  - What are the key signs of a sustainable economic recovery?
  - How vital are efforts to restore the soundness of creditor and debtor balance sheets, and how can this be achieved?
  - While balance-sheet repair proceeds, how can fiscal and monetary policies be deployed to support growth and combat deflation?
  - How should policymakers design and articulate exit strategies, even if implemented only after a durable recovery takes hold?
  - What could be the longer-term legacies of the crisis for growth, inflation and public debt?

### Rationale for using Japan’s experience
- The paper recalls Japan’s banking crisis of the 1990s (the “lost decade”) to draw potential implications for the global outlook and policy design.
- Parallels highlighted between Japan’s lost decade and the Great Recession:
  - Both crises originated in the bursting of asset bubbles fueled by lax financial regulation and irrational exuberance, against the backdrop of escalating private debt.
  - The asset collapse raised liquidity and solvency concerns for systemically important institutions, weakening growth and requiring unprecedented policy support (macroeconomic stimulus, financial interventions).
  - Attention eventually had to turn to unwinding exceptional macroeconomic and financial interventions as recovery emerged.

### Structure of the paper
- Section II reviews Japan’s experience with nascent recoveries during its banking crisis and outlines key ingredients to its lasting resurgence; it also discusses policy responses and exit strategies.
- Section III places these experiences in the current context to assess the likely durability of current green shoots and to lay out the policy stance needed for a sustained global recovery.
- Section IV concludes.
- The Appendix presents a chronology of Japan’s key policy actions during the banking crisis.

---

### Japan’s Lost Decade: From Green Shoots to Enduring Recovery

### Overview and three phases
- Japan’s lost decade was not uninterrupted decline but involved three distinct phases, with two episodes of temporary recovery followed by renewed stress due to adverse external shocks.
- Recovery stalled twice when the external environment deteriorated:
  - Phase 1 (1990–97): Crisis outbreak and fragile recovery.
  - Phase 2 (1997–2000): Systemic stress and second recovery attempt.
  - Phase 3 (2001–03): Renewed systemic stress followed by sustained recovery.
- A more durable recovery required addressing financial and corporate sector problems, after which policy stimulus and favorable external conditions (notably demand from China) reinvigorated private demand.

### Phase 1: 1990–97 — Crisis outbreak and fragile recovery
- Origins and initial impact:
  - Stock and real estate bubbles collapsed in 1989–1990 after having tripled during the latter half of the 1980s.
  - Private debt had escalated leading up to the crisis, driven primarily by firms rather than households.
- Pre-crisis historical context:
  - For two decades prior, Japan expanded by almost 4 percent annually after the oil shock of 1973 (compared to an OECD average of around 2¾ percent).
  - Unemployment had been less than half the OECD average and inflation almost 3 percentage points lower.
- Early post-bubble performance:
  - Growth stagnated, averaging 1½ percent between 1991 and 1994.
  - Unemployment ticked up; inflation fell gradually from highs of around 3½ percent.
  - Credit growth remained relatively resilient and official nonperforming loans (NPLs) were low initially.
- Policy response and temporary recovery:
  - The Bank of Japan cut policy rates to near zero by 1995, and successive fiscal stimulus packages were implemented.
  - A recovery appeared from 1994: growth and inflation picked up, unemployment leveled off, stock market rallied, industrial production recovered via an inventory-cycle correction.
  - Signs of recovery led to withdrawal of policy support, including a fiscal consolidation effort launched in April 1997 (the consumption tax rate was raised to 5 percent from 3 percent in 1997, and a temporary income tax cut was lifted; social security premiums were raised).

### Phase 2: 1997–2000 — Systemic stress and second recovery attempt
- The Asian financial crisis of 1997 triggered a more virulent phase and almost led to financial meltdown:
  - The bursting bubbles had left large NPLs masked by regulatory forbearance; the Asian crisis exposed these problems.
  - Interbank markets seized, large-scale failures occurred, and a credit crunch ensued; the economy contracted in both 1998 and 1999 (first back-to-back negative growth since the 1970s oil shocks).
- Policy response and temporary stabilization:
  - Capital injections into the banking system followed, largely without conditions and without adequately tackling NPLs.
  - Policy stimulus was reintroduced via larger fiscal packages and a shift to a zero-interest rate policy.
  - These actions supported a pickup in activity; the policy rate was raised by 25 basis points in August 2000.

### Phase 3: 2001–03 — Renewed stress followed by sustained recovery
- IT bubble collapse and renewed stress:
  - The global information technology bubble collapse from March 2000 strained corporate profits and the fragile banking system.
  - With the economy barely growing in 2001 and 2002, a large output gap opened; unemployment rose to a post-war high of 5½ percent in 2002.
  - NPL ratios peaked at almost 9 percent.
  - Public debt rose in net terms to nearly 75 percent of GDP.
- Financial and corporate restructuring enabled recovery:
  - A comprehensive strategy in 2002–03 addressed bank problem loans and capital shortages more aggressively, restoring confidence.
  - Corporates shed the “triple excesses” of debt, capacity, and labor; corporate debt (which had risen from 80 percent of GDP in the early 1980s to 120 percent in 1995) returned to prebubble levels by 2004.
  - Bank losses were much larger than first envisioned—at over ¥100 trillion—and around ¥47 trillion in public funds was needed to dispose of NPLs and recapitalize banks.
  - Nearly three-fourths of the public funds used in financial sector interventions have been recovered to date.
- Characteristics of the sustained expansion:
  - From 2003 to 2007, growth averaged 2 percent.
  - Private domestic demand was stronger, supported by a revitalized banking system and healthier corporates; credit flowed again, employment rose, the stock market surged, and investment picked up.
  - Favorable global conditions and a real effective depreciation associated with deflation and a weak yen benefited the recovery; net exports accounted for around a third of Japan’s growth during this period.

---

### Revisiting Japan’s Policy Responses

### The primacy of financial and corporate interventions
- Strategy and outcomes:
  - The Japanese authorities focused on restructuring banks: forcing recognition of problem loans, raising new capital, and in some cases using public funds or facilitating exits.
  - At over ¥100 trillion, bank losses far exceeded early estimates; around ¥47 trillion in public funds was used to deal with NPLs and recapitalize banks.
  - Tighter supervision, judicious use of public funds, and a sound framework for restructuring distressed assets helped restore financial health and support recovery.
  - Nearly three-fourths of the public funds used have been recovered.
- Costs of delay:
  - Delays in recognizing problem loans exacerbated the crisis and postponed sustained recovery.
  - Weak accounting practices and regulatory forbearance masked the NPL problem; this reflected a lack of understanding of the NPL scale and an initial belief that recovery would be quick.
  - The delay proved costly in taxpayer funds and in economic performance, as insolvent “zombie” firms lingered and constrained investment by sound firms.
  - Earlier recognition and provisioning would likely have revealed capital shortages sooner and jump-started restructuring.

*Source: IMF Working Paper, "Introduction" section.*

### 16.      Liquidity provision helped forestall an immediate systemic crisis, but could not

### 16.      Liquidity provision helped forestall an immediate systemic crisis, but could not

### Liquidity provision, capital shortage, and credit constraints
- Exceptional liquidity was required to stabilize the banking system, but without recognizing losses and addressing capital shortages its effectiveness diminished over time.
- Because of the capital shortage, banks were unable to extend new credit or take on risk, raising concerns over a credit crunch.
- Regulatory forbearance, and weak incentives for management and shareholders, limited actions to raise new equity or write down bad loans.
- The Bank of Japan (BoJ) and others pushed for government injection of public funds to free banks’ capital constraints and revive the credit channel.

### Public funds, conditionality, and outcomes
- Public funds that were conditional on equity writedowns and steps to dispose of bad assets ultimately proved effective.
- Earlier capital injections with relatively few conditions helped recapitalization but did not resolve the NPL problem.
- Success required: realistic valuation of assets, accelerating NPL disposals, stricter conditions on capital injections, and close monitoring by the FSA under an agreed reorganization plan.
- Public funds also promoted financial consolidation, with several large banks and many smaller institutions either closed or merged.

### Centralized asset management and NPL resolution
- In 2003, the Industrial Revitalization Corporation of Japan (IRCJ) was established to purchase distressed loans and work with creditors on restructuring.
- The Resolution and Collection Corporation (RCC) was charged with disposing of bad assets and became more aggressive in selling and restructuring its non-performing asset portfolio over time.
- Government purchases and sales of NPLs through the RCC and the IRCJ facilitated price discovery, resolved credit disputes, and provided legal clarity and accountability.
- IRCJ generated a small profit before shutting down in 2007, and interventions allowed bank management to focus on new lending and business restructuring.

### Private-sector-led restructuring and insolvency reforms
- Large write-offs and debt restructuring by banks were instrumental in corporate deleveraging.
- Recovery values depended on private sector leadership in restructuring; reforms of the insolvency system and out-of-court workouts helped create a market for restructuring distressed assets and drew in private capital and expertise.
- Improvements to accounting and governance frameworks and bankruptcy reforms provided tools for private-sector restructuring.

### Scale of fiscal support and recovery metrics
- The government injected public funds of nearly ¥47 trillion (10 percent of 2002 GDP) to recapitalize the banking system and dispose of problem loans.
- In 2003, banks’ share prices started to recover as NPLs trended down and capital ratios stabilized.
- Nearly three-quarters of the ¥12½ trillion of public capital has been repaid to date, and about 80 percent of total funds are expected to be recovered.

### Re-assessing the effectiveness of fiscal stimulus
- Average deficits of more than 5 percent of GDP between 1993 and 2000 contributed to net debt rising to 60 percent of GDP.
- Fiscal stimulus took the form of public investment, support for SMEs, employment assistance, and tax cuts, but the economy remained largely stagnant until the early 2000s.
- The cyclically adjusted (structural) deficit increased only modestly between 1994 and 1998; after 1998 fiscal policy became truly expansionary with a more significant widening of the structural deficit.
- Constraints on fiscal impact included:
  - Public investment smaller than headline numbers; land purchases were as high as 30 percent of project size in some cases.
  - About 15 percent of budgeted public investment remained unused partly because local governments were unable to obtain matching funds.
  - Early stimulus was stop-start; a consumption tax increase in April 1997 and the Asian crisis led to a fall in household spending and renewed recession.
  - Declining fiscal multipliers (estimates range 0.4–2.0), with Cabinet Office estimates for public investment multiplier declining to 1.1 in 2004 from 1.3 in 1991.
  - Shifts in spending composition: share of central government spending on social security increased to 3.5 percent of GDP in 2000 from 2.6 percent in 1990.
  - Possible Ricardian effects: concerns over future tax increases and rapid rise in public debt may have suppressed private demand.

### Monetary policy, credit easing, and quantitative easing
- When policy rates hit the lower bound, the BoJ shifted to a zero interest rate policy (ZIRP) in February 1999: policy rate lowered to 0.15 percent, then to as low as 0.02 percent.
- In March 2001 the BoJ adopted “quantitative easing,” targeting the outstanding balance of banks’ current accounts at the central bank and strengthening commitment to prolonged accommodation (the “policy duration” effect).
- The BoJ increased purchases of long-term government bonds from ¥400 billion to ¥1.2 trillion per month and expanded purchasable assets to include commercial paper, corporate bonds, equities and asset-backed securities (actual amounts relatively limited).
- BoJ balance sheet increased from ¥91 trillion (18 percent of GDP) in 1998 to about ¥155 trillion (31 percent of GDP) in 2006.
- The BoJ offered to purchase banks’ equity holdings; the amount was only 1.3 percent of the BoJ’s total assets and was smaller risk relative to its JGB holdings (¥65 trillion).

### Impacts, limits, and costs of unconventional measures
- Unconventional measures helped support corporate lending and buttress banks’ capital positions, including temporary lending facilities in 1998 and ABS/ABCP purchases backing SME loans in 2003.
- Quantitative easing did not immediately arrest deflation or lead to an expansion in bank credit, due to banks’ unwillingness to lend and subdued corporate demand amid deleveraging.
- Weaknesses manifested in a sharp decrease in the money multiplier, disrupting normal monetary transmission.
- Some evidence suggests liquidity provision reduced interbank risk premia and the policy duration effect helped lower interest rates at shorter maturities once recovery took hold.
- Significant negative side effects of prolonged unconventional policy included breakdown in money markets, reduced market activity, compressed credit spreads and bank profits, and reduced incentives for restructuring.
- These costs increased the longer the zero interest rate policy remained in place, necessitating rapid restructuring of affected balance sheets.

### Exit strategies and long-term fiscal implications
- Policymakers faced a dilemma of maintaining stimulus long enough to prevent deflation while timing exit to avoid new imbalances and rising public debt.
- Japan found unwinding fiscal policies particularly challenging: a 1997 law to reduce deficits was scrapped; only in mid-2001 was a target for achieving a primary balance announced, by which time net debt had quintupled on weak growth, stagnant tax revenues, and increased spending.
- The income tax cut introduced in the late 1990s was fully lifted only in 2007, contributing to persistently large deficits and a continued rise in public debt.
- Elevated public debt—gross debt approaching 200 percent of GDP—continues to limit policy flexibility despite low long-term yields supported by available domestic savings.

*Source: IMF working paper chapter content.*

### 33.      Exit was more successful in the

### 33.      Exit was more successful in the

### Monetary exit and BoJ strategy
- The Bank of Japan (BoJ) was able to end quantitative easing and smoothly unwind its balance sheet.
- October 2003: the BoJ clarified the timing of its exit by announcing two necessary conditions: that core CPI be nonnegative for a few months and be forecasted to remain positive by a majority of Policy Board members.
- March 2006: with the conditions met, the BoJ announced it would gradually drain liquidity while keeping overnight interest rates effectively at zero.
- By July 2006: the BoJ had smoothly transitioned to a more normal monetary framework, with current account balances normalizing and the policy rate raised.
- Because credit easing relied mainly on extended liquidity operations and the purchase of government securities, the BoJ exited through normal open market operations without selling Japanese government bonds (JGBs) or issuing its own bills.
- Given its large holdings of short-dated government paper and subdued inflationary pressures during the recovery, the BoJ avoided losses and yield spikes by holding JGBs to maturity.
- Outright purchases of asset-backed securities and asset-backed commercial paper carried sunset clauses and were of short maturity, facilitating eventual unwinding.
- The money market, which had withered during the late 1990s, was revived as institutions gradually reduced their reliance on the BoJ for funding.

### Financial sector interventions and exit challenges
- Fully unwinding financial sector interventions proved more difficult.
- Exit strategy for divesting public shares in the banking system and other interventions took longer to design.
- To restore market discipline and minimize moral hazard:
  - Blanket guarantees were replaced with partial deposit insurance.
  - Public funds were gradually repaid.
- Nearly three-fourths of the 10 percent of GDP in public funds needed to dispose of NPLs and recapitalize banks have been recouped (Table 2).
- 10.4 trillion yen is covered by the taxpayers, with the remaining amount scheduled to be covered by deposit insurance fees paid by financial institutions.
- The BoJ has been unable to fully unwind its purchases of equities held by banks, and some banks have been unable to fully repay their public funds.
- Withdrawal of public support of SMEs (primarily in the form of generous credit guarantees) has been relatively gradual and may have held back needed restructuring of the sector.

### Long-term scars from the crisis
- Persistently lower investment, weak price pressures, and a significant rise in public debt have manifested as long-term scars.
- Compared to rates reached in the 1980s:
  - Gross fixed capital formation has on average been more than 5 percent of GDP lower.
  - Average growth has fallen by half.
- Asset prices have never fully rebounded:
  - The stock market remains some 40 percent below its precrisis high.
  - House prices remain some 70 percent below their precrisis high.
- Deflationary pressures persisted:
  - Headline inflation only edged into positive territory from 2006.
  - Policy rates peaked at a mere 50 basis points.

### Implications for the global recovery (lessons from Japan)
- The beginning of the end of the Great Recession appears in sight, but a global repeat of the lost decade is not inevitable.
- Key observations and cautions from Japan’s experience:
  - Green shoots do not guarantee a recovery; sustained upturns required indicators across trade, financial conditions, and private domestic demand to display tangible recovery.
  - In Japan’s first two recovery attempts, exports and industrial production recovered strongly but little spillover occurred to private demand; underlying momentum was weak and financial/corporate fragilities left the economy vulnerable to external shocks.
  - In the successful third episode, private demand—particularly corporate investment—was stronger after firms cleaned up balance sheets and the financial system was recapitalized.
  - Financial market indicators, especially the stock market, tended to be the first to show recovery; inventory corrections supported production; consumer and business sentiment improved in middle stages; private credit, house prices, and the labor market turned only in the final stage.
- Current parallels and contrasts (as of the period reviewed):
  - Advanced economies outside Asia show patterns resembling Japan’s incipient recovery attempts: trade and financial indicators showing partial recovery, but private domestic demand remains weak.
    - Trade related: global stimulus efforts bolstering exports; inventory adjustment progressing; production recovery yet to take hold.
    - Financial markets: recovery apparent in some segments (led by the United States); money markets in the United Kingdom recovered strongly; overall credit conditions remain exceptionally tight for many households and firms.
    - Private domestic demand: improvements lagging; consumer and business sentiment generally depressed; spending subdued and labor markets extremely weak.
  - Emerging Asia (in particular China and India) rebounded much more quickly:
    - Sizable monetary and fiscal stimulus, rebound in global risk appetite, and unwinding of inventory adjustments underpinned recovery.
    - Sound pre-crisis macroeconomic management allowed more aggressive policy responses.
    - Private sector balance sheets were generally in better condition, enabling continued or accelerating credit expansion (notably in China), supporting consumption and investment.
    - Nonetheless, private domestic demand in export-oriented Asian economies still looked vulnerable due to external demand fragility.
- Broader risks highlighted by Japan’s experience:
  - Lingering financial fragilities leave economies vulnerable to adverse shocks and can magnify their impact; on two occasions in Japan adverse external shocks were amplified by a weak banking system, pushing the economy back into stagnation.
  - Given downside risks and strained financial systems and household balance sheets in advanced economies, the possibility of a double dip cannot be discounted.
  - A double-dip recession would necessitate further rounds of aggressive and costly macroeconomic and financial interventions, potentially worsening longer-run outcomes.

*Source: IMF staff analysis contained in the supplied content unit.*

### 43.       First, a lasting recovery is likely to depend on concerted efforts to resolve

### _wp09282 - 43.       First, a lasting recovery is likely to depend on concerted efforts to resolve

### Financial-sector and debtor imbalances: evidence and implications from Japan
- Lasting recovery likely depends on resolving financial sector and debtor imbalances; Japan’s recovery only took hold after corporate debt returned to prebubble levels and banks disposed of distressed loans and were adequately recapitalized.
- Household debt observation: Figure 22 indicates household debt (In percent of GDP) for US, UK, EU over 1999–2007 (visual data referenced).
- Key findings and risks:
  - Recognizing bank losses early and fully could identify capital shortages and jumpstart restructuring. Global banks face potential writedowns of around $2.8 trillion (IMF, 2009). Around half of these still are still to be written down, roughly where Japan stood in the middle of its crisis.
  - Delays in recognizing problem loans could exacerbate the financial crisis and postpone a sustained recovery.
  - Uncertainty over the value of nonperforming loans (NPLs) can spill over to sound banks and hinder raising private capital; calls for continued close monitoring and regular stress-testing as a prolonged downturn could place further strains on bank capital.
- Policy recommendations drawn from Japan’s experience:
  - Public funds can recapitalize banks and dispose of bad assets; Japan used asset management companies, liability protection, and public capital injections, but the system remained dysfunctional until banks cleaned up balance sheets and disposed of bad assets. The ultimate fiscal cost was significantly lower than upfront expenses because much was recovered once the economy stabilized.
  - Rigorous inspection of bank asset quality (discounted cash flow methodology, mark-to-market accounting, cross-bank cross-checks) helps clarify worst-case losses and strengthens restructuring incentives.
  - Centralized asset management approaches (institutions with clear mandate to buy distressed assets and recover value) could accelerate clean-up, enhance price discovery, resolve credit disputes, and may cost far less than upfront estimates if asset values recover.
  - Overcoming public resistance to bailouts and stigma attached to public capital is key; effective communication linking financial stability and sustained recovery can bolster support for use of public funds.
  - Rehabilitating distressed borrowers supports bank restructuring; financial and corporate restructuring in Japan were mutually reinforcing. Instruments to encourage banks to directly restructure distressed mortgages (including through the bankruptcy system) may be needed.
  - A sound private-sector-led framework (bankruptcy reform, out-of-court workouts, debt-equity swaps) aided rehabilitation of distressed but creditworthy firms; analogous personal bankruptcy reforms and improvements to accounting and governance frameworks may be warranted.

### Fiscal and monetary stimulus while restructuring proceeds
- While restructuring is underway and until recovery is established, policy stimulus may need to be maintained to give banks and households time to rebuild balance sheets and lay foundations for renewed growth.
- Fiscal policy lessons:
  - Successful fiscal stimulus hinges on identifying spending with high multipliers; large multipliers are needed to justify spending against debt accumulation and potential interest-rate effects (Figure 23 referenced).
  - On public investment, multipliers higher than unity may be needed; priority on projects likely to stimulate private demand. Transfers could be targeted at lower-income households with higher marginal propensity to consume.
  - Restoring the credit function of banking sector maximizes fiscal stimulus impact; without sound capital buffers, fiscal stimulus may be short-lived and ineffective, as in Japan.
  - Prolonged delay in restoring fiscal position via tax increases and expenditure reforms could be costly. Announcing timing for eliminating tax cuts or precommitting to revenue increases may minimize political pressures and Ricardian effects. Consider medium-term revenue-neutral measures (e.g., accelerated capital depreciation).
- Monetary policy lessons:
  - If downside risks materialize and private markets remain dysfunctional, additional direct measures to ease monetary conditions to jump-start credit could be considered, including targeted purchases of agency and private (non guaranteed) debt, equities, or direct loans to individuals, corporations and partnerships (Figure 24 referenced).
  - Temporary and limited coordination between fiscal and monetary authorities may be warranted (e.g., increased government bond purchases) to lower long-term yields, alleviate crowding-out, influence expectations, and flatten the yield curve.
  - Risks to central bank balance sheet and independence must be balanced; in Japan risks were minimized by relatively limited purchases of non-conventional assets. In some advanced economies, larger purchases of private debt imply more significant default risks, placing a premium on careful risk management and high transparency. Where credit risk is significant, Treasury agencies may be more appropriate operators.
  - Clear communication can help manage market expectations about unconventional policies; stronger commitment to prolonged accommodative stance and clearer near-term objectives and relevant variables (e.g., measures of credit tightening) may improve transparency. Discussing upside and downside risks to the inflation outlook in public pronouncements is advisable.
  - Unconventional policies have costly side-effects and are not a substitute for balance-sheet restructuring; functioning financial systems and healthy borrowers are needed to transmit monetary loosening benefits and provide plausible exit strategies.

### Exit strategies and medium-term considerations
- Clear plans for exit while maintaining support as long as needed are beneficial; timing of exit is challenging under uncertainty about economic strength and financial vulnerabilities.
- Lessons and recommendations:
  - Policymakers must balance avoiding premature withdrawal of stimulus before imbalances are redressed and avoiding support maintained too long at expense of longer-run outcomes. Japan’s stimulus effectiveness waned over time amid rising public debt and banking problems.
  - Global coordination of exit strategies is important given the crisis’ global scale.
  - Outlining a concrete medium-term fiscal consolidation strategy could help manage the balance between support and long-term debt sustainability; aggressive fiscal stimulus is projected to rapidly raise public debt levels and markets may require convincing this trend will reverse.
  - Laying out policy options to achieve desired fiscal adjustment can address long-run spending needs associated with aging and expanding safety nets.
  - Exit strategy for exceptional monetary policies needs convincing articulation to guide market expectations; the most desirable exit is a recovery of investors’ risk appetite and normalization of credit markets, as happened in Japan. Communicating how and under what conditions monetary stimulus would be withdrawn can aid smooth transition.
  - Making available diverse liquidity-management tools (e.g., granting central banks authority to issue their own debt) would enhance policy flexibility and credibility.
  - Strategy for unwinding financial and corporate sector policies is needed to minimize distortions and fiscal risks; likely involves tightening terms on support facilities and gradually reducing guarantees and subsidies.

### Structural reforms and longer-run legacies
- Post-bubble recessions can cause long-term output losses through risk repricing, deleveraging, and financial restructuring that dampen investment and curtail credit.
- Japan’s long-run outcomes:
  - Growth rates have not returned to precrisis levels, falling to only half the 4 percent rate achieved during the 1980s (Figure 25 referenced).
  - Broader experience suggests financial crises result in permanent output losses (references noted in text).
- Implications:
  - Structural reforms and global rebalancing are likely imperative to enhance productivity and ensure robust long-term growth, especially because a weak global environment may limit prospects for an export-led recovery.

### Conclusions and four broad lessons for policymakers
- Green shoots are not a guarantee of recovery; caution about the outlook is warranted.
- Financial fragilities can leave economies vulnerable to shocks and should be resolved for a durable recovery.
- Well-calibrated macroeconomic stimulus can facilitate adjustment and buy time but carries increasing costs.
- Clear medium-term plans for exiting policy support may help contain longer-term legacies of the crisis.

*Source: _wp09282 - section beginning “First, a lasting recovery is likely to depend on concerted efforts to resolve” (excerpt).*

### Box 1. Japan: Key Financial System Reforms, 1996–2003

### Box 1. Japan: Key Financial System Reforms, 1996–2003

### Key regulatory and institutional reforms (1996–2003)
- 1996: The “Big Bang.”
  - Removal of the remaining legal barriers separating ownership of banks, trust banks, securities firms, and insurance companies; removal of the long-standing ban on holding companies, allowing the creation of financial groups.
  - Safety net enhanced including temporary comprehensive deposit insurance.
- 1998:
  - Banking law reform. Prompt corrective action (PCA) procedures established.
  - Financial Supervisory Agency established under Financial Reconstruction Commission (FRC) to oversee rehabilitation of the financial sector and improve supervision.
  - Inspection manual prepared and published, introducing so-called self-assessment process to promote more effective loan valuation and provisioning practices.
  - Securities and Exchange Surveillance Commission (SESC) moved from the Ministry of Finance (MoF) to the Financial Supervisory Agency.
  - Bank of Japan (BoJ) law passed, establishing an independent central bank. BoJ’s right to examine counterparty financial institutions explicitly confirmed.
- 1999:
  - Insolvency law reformed under Civil Rehabilitation Law.
  - Disclosure regime enhanced. Banks required to disclose more information on asset quality and unrealized gains/losses on securities’ holdings.
  - Resolution and Collection Corporation (RCC) created to collect bad loans from failed housing loan companies, banks, and credit cooperatives.
- 2000:
  - Safety net enhanced. New deposit insurance law codifying the safety net including a crisis management framework.
  - PCA procedures strengthened.
  - Accounting reforms introduced, including consolidated accounting and mandatory use of market values for securities.
  - Financial Supervisory Agency renamed Financial Services Agency (FSA).
- 2001:
  - FSA takes over functions of the FRC. Position of Minister for Financial Services within the Cabinet set up.
  - Accounting Standards Board of Japan established.
  - Special inspections by the FSA leading to more realistic loan loss provisioning.
- 2002:
  - Comprehensive deposit insurance withdrawn; large time deposits no longer insured.
  - Government and BoJ establish schemes for purchasing bank equity holdings.
  - Program for Financial Revival published, key elements including:
    - (i) special inspection of major banks’ loan classification and provisioning;
    - (ii) introducing discounted cash flow (DCF) methodology for provisioning loans to large “special attention” borrowers;
    - (iii) harmonizing loan classification for large borrowers across banks;
    - (iv) disclosing the gap between major banks’ self-assessment of problem loans and FSA assessment;
    - (v) external auditing of capital adequacy ratios, starting in FY 2003.
- 2003:
  - Industrial Revitalization Corporation of Japan (IRCJ) set up to promote more effective corporate restructuring.
  - Another round of special inspections leading banks to raise external capital and set up asset resolution companies, often in conjunction with international investors.

### Public recapitalization and injections (1998–1999)
- Early framework:
  - New Financial Crisis Management Committee to identify banks with capital shortages and the amounts to be injected; regulators’ obligations defined to narrow scope for regulatory forbearance.
- Three stages of public funds injection:
  - February 1998:
    - Government made ¥30 trillion in public funds available, of which ¥13 trillion (around 2½ percent of GDP) was for capital injection and the rest for deposit insurance.
    - By end-March, ¥1.8 trillion had been disbursed almost equally to 21 large banks but without a comprehensive examination or clean-up of bank balance sheets.
  - October 1998:
    - Diet doubled the pool of public funds to ¥60 trillion (12 percent of GDP), of which ¥25 trillion set aside for capital injection into solvent banks; ¥18 trillion for resolving failing banks; rest allocated to deposit insurance.
    - Despite these efforts, Long-term Credit Bank of Japan and Nippon Credit Bank failed and were temporarily nationalized.
  - March 1999:
    - Additional ¥7½ trillion injected into 15 major banks.
    - To qualify, each bank required to submit a restructuring plan including plans for raising new capital from the private sector, reviewed quarterly.
    - If the FSA was not satisfied, it could convert preferred stock holdings to common stocks after a grace period and demand management changes as the largest shareholder.

### Assessment of initial recapitalization efforts
- Findings:
  - BoJ operations stabilized credit markets (LIBOR spreads for Japanese banks came down starting in 1998; volatility and level of short-term interest rates were reduced) but did not solve banks’ capital shortage.
  - Banks’ risk premium remained high as overseas banks priced additional risk from weak capital base and large NPL holdings.
  - Early public recapitalizations came with few conditions and did not tackle the non-performing loan (NPL) problem, failing to restore health to the banking system or generate sustained macroeconomic impact.
  - Resulted in a vicious cycle: bad loan problem, weak economy, low investor confidence further weakened banks and blunted effectiveness of macroeconomic stimulus.

### Comprehensive strategy to address the NPL problem (post-1999, emphasized from 2002)
- Four key elements of the public-funds-based strategy:
  - Ensuring realistic valuation of bad assets:
    - Special inspections by the FSA focusing on large borrowers at major banks confirmed self-assessments were overly optimistic and NPLs were significantly understated.
    - From 2002, prudential norms strengthened by introducing mark-to-market accounting, stricter loan classification and loan-loss provisioning.
    - Introduction of discounted cash flow methodology to value loans and cross-check of loan classification across major creditors improved provisioning and incentives for restructuring.
  - Accelerating disposal of nonperforming loans:
    - Under the “Program for Financial Revival,” major banks required to accelerate disposal of NPLs within 2–3 years by selling to the market, pursuing bankruptcy, or rehabilitating borrowers through out-of-court workouts.
    - Remaining loans to be sold to the RCC charged with disposing of bad assets of failed banks.
    - Contrast with earlier warehousing of bad jusen loans in the early 1990s: RCC and banks looked more to sell and restructure NPL portfolios.
  - Improving bank capital:
    - Around ¥12½ trillion of public funds (including past injections) used to recapitalize both major and regional banks, mainly through preferred stock or subordinated debt.
    - In exchange for public funds, banks required to write down capital of existing shareholders, replace senior management, and submit reorganization plans for regular FSA review.
    - Governance reforms required consistent with Basel Committee guidelines, such as appointing outside directors and establishing a board audit committee.
    - Limits placed on the amount of deferred tax assets banks could count towards Tier 1 capital ratio; deferred tax assets in 2003 accounted for nearly one-half of Tier-1 capital in major banks and generated market concerns over quality and ability of bank capital to absorb further losses.
  - Strengthening supervision:
    - 1998 creation of FSA consolidated supervision from MoF and other agencies into a single entity.
    - New law authorized FSA to prescribe prudential rules and apply prompt corrective action when rules were breached or institutions viewed as unsafe or unsound.

### Measures to facilitate corporate restructuring
- 2003:
  - Industrial Revitalization Corporation of Japan (IRCJ) established to purchase distressed loans from banks (up to around ¥1 trillion) and work with creditors in restructuring.
  - Insolvency system reformed by introducing a faster and more efficient “Civil Rehabilitation Law.”
  - Guidelines for out-of-court corporate workouts introduced.
  - Accounting and auditing framework upgraded.
- Note on deferred tax assets:
  - Deferred tax assets in 2003 accounted for nearly one-half of Tier-1 capital in major banks.

### Fiscal policy actions in the 1990s (overview of stimulus composition and magnitudes)
- Stimulus packages:
  - Headline total: ¥140 trillion, including credit guarantees and public investment.
  - Actual spending: about ¥40 trillion (8 percent of 2000 GDP).
- Main elements:
  - Public works:
    - On average, public works accounted for about 40 percent of Japan’s stimulus measures.
    - Late 1990s public investment shifted toward IT-related infrastructure.
  - SME finance:
    - Special credit guarantee program provided 100 percent coverage to banks against losses.
    - Guarantees reached nearly ¥30 trillion (6 percent of GDP) by 2001.
  - Employment support:
    - Late 1990s packages gave greater weight to employment support and social security spending.
    - Cash vouchers of ¥0.7 trillion distributed in 1999 to households potentially liquidity-constrained.
  - Tax measures:
    - Tax cut of about ¥5.5 trillion (1.1 percent of GDP) enacted in 1994.
    - 1997 medium-term consolidation: consumption tax raised by 2 percentage points and temporary part of earlier tax cut abolished, raising overall tax burden by some ¥7.0 trillion (1.4 percent of GDP).
    - Temporary income tax cut of about ¥4.0 trillion in 1998, followed by another tax cut of ¥6.6 trillion in 1999.

### Monetary policy actions and unconventional measures
- Policy rate path and institutional change:
  - Between mid-1991 and mid-1995, discount rate lowered eight times from 6 to fractional levels.
  - BoJ changed target to overnight interest rate; initial target set at 0.5 percent.
  - 1998: BoJ gained formal independence from the MoF under the New Japan Act of 1998; Monetary Policy Board gained additional members.
- Expansion of BoJ monetary instruments:
  - Broadened eligible collateral to include corporate bonds, loans on deeds, ABCP and other ABS.
  - Extended maturity of bill purchases and JGB repos from six months to a year.
  - Increased number of counterparties for JGB purchases and commercial paper repo operations.
- Zero interest rate policy (ZIRP):
  - February 1999: BoJ shifted to ZIRP; policy rate lowered to 0.15 percent, then to rates as low as 0.02 percent.
  - August 2000: BoJ lifted ZIRP and raised rates to 0.25 percent; returned to zero within seven months as the economy fell back into recession.
- Quantitative easing:
  - March 2001: BoJ introduced quantitative easing policy, targeting outstanding balance of banks’ current accounts at the BoJ.
  - Initial target set at around ¥5 trillion; increased in steps to around ¥35 trillion by 2004 as credit growth remained lackluster.
- Liquidity and credit support:
  - 1998 temporary lending facility to refinance 50 percent of the increase in loans provided by financial institutions during the fourth quarter of the year.
  - 2003 program to assist SMEs by purchasing ABS and ABCP backed by SME loans rated BB or higher.
- Support for bank capital and asset holdings:
  - Banks’ large equity holdings were ¥27 trillion or nearly 150 percent of their Tier 1 capital, constraining credit extension.
  - 2002 BoJ program to purchase equity rated BBB- or higher directly from banks at market prices.
  - BoJ purchases of equities during 2002–04 reached ¥2.1 trillion ($18 billion), representing around 6 percent of banks’ total equity holdings.
- Foreign exchange intervention:
  - Ministry of Finance undertook large-scale FX interventions in 2003 and early 2004, selling ¥20 trillion in 2003 and ¥15 trillion in the first quarter of 2004 to stabilize the yen.

*Source: IMF (2003).*

### 19.      Having relied mainly on ordinary operational tools and the purchase of

### 19.      Having relied mainly on ordinary operational tools and the purchase of government securities, the BoJ was eventually able to exit from quantitative easing

### Exit from Quantitative Easing
- The Bank of Japan (BoJ) relied mainly on ordinary operational tools and the purchase of government securities to implement quantitative easing.
- The BoJ was eventually able to exit from quantitative easing by shrinking its balance sheet through open market operations and without selling government bonds.

### Balance sheet dynamics (March–July 2006)
- Between March and July 2006, the BoJ's balance sheet shrunk from ¥145 trillion to ¥116.
- This decline largely reflected:
  - a ¥20 trillion decrease in funds supplying operations, and
  - a natural unwinding of relatively short-maturity government bonds that had been sold to the BoJ by financial institutions during 2005–6.

### Money demand and the "banknote rule"
- As money demand picked up, the BoJ was able to meet its self imposed “banknote rule” (the requirement to keep outstanding government bond holdings below the amount of banknotes) without resorting to outright sales of JGBs.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp09282.pdf*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2009/_wp09282.pdf_