Annual Report on the Japanese
Economy and Public Finance
- No Gains without Reforms II -
Government of Japan
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Overview of the Capacity for Economic Recovery
Section 3 Recent Development of Fiscal and Monetary Policies
The Japanese government repeatedly implemented economic stimulus packages to cope with prolonged recession since the collapse of the bubble economy and the Bank of Japan has been continuing easy monetary policies. But these policies failed to lead to a sustainable economic recovery led by private demand. Meanwhile, the government has come to huge fiscal debt due to fiscal stimulus packages, increase in social security-related expenses, and decrease in tax revenues caused by the prolonged recession and tax cuts.
The government needs to promote fiscal structural reform. The main purposes of the reform are (i) reduction of the huge fiscal deficits and (ii) review of government spending. The question is how to promote the fiscal structural reform amid the ongoing deflation. The Bank of Japan, for its part, is required to carry out effective monetary easing policies to overcome the deflation. The Japanese central bank has been taking quantitative monetary easing policies since March 2001, but their effect on the economy is not necessarily clear.
In this section, the problems involved in the fiscal and monetary policies and their effects on the economy will be examined.
1. Impact of the Fiscal Structural Reform on the Macro Economy
Impact of the fiscal structural reform on the macro economyFirst, let' s take a look at the scale of national and local governments' expenditures. On an initial general account budget basis of national government, starting 85.0 trillion yen in FY2000, decreased to 82.7 trillion yen in FY2001 and to 81.2 trillion yen in FY2002. Under the initial local public financial program, expenditures increased to 89.3 trillion yen in FY2001 from 88.9 trillion yen in FY2000, but decreased to 87.6 trillion yen in FY2002.
2. Macro Effects of the Quantitative Easing
Expected effects of the quantitative easing
Since the collapse of the bubble economy, monetary policy has basically been broadly accommodative conditions. Until March 2001, the Bank of Japan used short-term interest rates as its operating target and lowered the rates continuously. For example, the official discount rate was lowered a total of nine times after July 1991 and dropped to 0.5% in 1995(75). In July 1995, the uncollateralized overnight call rate target was set at a level below the official discount rate. The target level of the uncollateralized overnight call rate was lowered to 0.25% in September 1998 and a "zero interest rate policy" was adopted in 1999(76).
However, with the economy entering a recession phase and the deflation continuing, it became necessary to ease the monetary policy moreover. In response, the Bank of Japan decided at its Monetary Policy Meeting in March 2001 to change its operating target to the outstanding balance of the current account at the BOJ and keep it in place until the deflation came to an end(77) and set its immediate target at around 5 trillion yen (an increase from around 4 trillion yen). This represents a shift to "quantitative easing" (78). Since then, the target level was raised gradually. In addition, the central bank increased the amount of its overnight purchases of long-term government bonds as a means to raise the level of the outstanding balance of the current account(79) at the BOJ.
The quantitative easing is said to have two effects in stimulating the economy. The first effect, which is common to that of past monetary easing measures, is to lower interest rates. However, since short-term interest rates are already close to zero percent and due to the non-negativity constraint of nominal interest rates, we cannot expect a further fall in short-term interest rates. Therefore, reductions in long-term interest rates are expected.
The second effect is through "portfolio rebalancing," which is particular to quantitative easing. This is the effect of creating the expectation that an increase in no-risk, no-return assets of the outstanding balance of current accounts at the BOJ would change asset managements not only financial institutions but also in the economy as a whole and would increase higher-risk, higher-return assets. Higher-risk, higher-return assets are, for example, bank loans. Needless to say, an increase in bank loans means that the real economy would be revitalized(80).
The effect through interest rates was observed to a certain extent at the time when the quantitative easing was adopted. Since how long short-term interest rates will remain at their current low level is important for long-term interest rates, the BOJ' s commitment to continuing the quantitative easing until the deflation comes to an end is significant in that it has set a "timeframe." However, with long-term interest rates already at low levels, we cannot expect more than a certain level of effect(81).
The next question is the effect of "portfolio rebalancing." We will examine the effect of the quantitative easing, focusing on this point. Our conclusion is that the transmission effect through bank loans, which has been known as the transmission mechanism of the monetary policy, is hardly working. But transmission of the effect through currency depreciation may be effective.
Monetary base shows high growth rates
First, let' s examine the change of the monetary base (See Figure 1-3-5).
Figure 1-3-5 Change of Money Supply
Before 1998, monetary base had been moving steadily due mainly to a rise in the amount of cash currency in circulation. Between 1999 and 2000, the contribution of the outstanding balance of current accounts at the BOJ increased due partly to the reduced opportunity cost caused by the zero interest rate policy and partly to increased liquidity preference triggered by the Y2K problem.
After the implementation of the quantitative easing in March 2001, the contribution of the outstanding balance of current accounts at the BOJ increased further in response to the Bank of Japan' s move to gradually raise the target of the outstanding balance of the current accounts of the BOJ(82). Meanwhile, the outstanding balance was kept at a level considerably higher than the lower range of the target. Cash in circulation also posted a high growth rate towards the end of FY2001 ahead of the proposed the removal of deposit insurance. As a result, the growth rate of monetary base rose from 1.2% (year-on-year) in March 2001, or shortly after the adoption of the quantitative easing, to 27.6% (year-on-year) in June 2002.
Such a high growth rate of monetary base is almost unprecedented(83). Even measured by a certain rule based on the growth rate of GDP and the velocity of money, the growth rate of monetary base is high, indicating that ample funds were supplied(84).
As a result, the call rate dropped to virtually zero percent. This is indeed a low level. However, if the optimal call rate level is calculated by, for example, a certain rule based on the growth rate of prices and supply-demand gap(85), it can be seen to be a negative interest rate. This suggests that the current call rate level has come to pass due to the non-negative constraint of nominal interest rates. It can be said that quantitative easing is necessary for this reason.
The growth of money supply is low
When monetary base increases, money supply normally increases as well via credit creation through bank loans. The ratio of the growth of money supply to the growth of monetary base is called the money multiplier.
When the money multiplier is constant, the growth rate of monetary base corresponds to the growth rate of money supply. However, a comparison of their year-on-year growth rates shows that while the year-on-year monthly growth of monetary base rose from 1.2% (March 2001) to 27.6% (June 2002), that of money supply (M2+CD) rose only slightly from 2.5% to 3.4%(86)(See Figure 1-3-5). This means that the money multiplier has declined sharply.
The money multiplier shows how much credit has been created through financial intermediary function. The money multiplier basically rises when the credit creation is active. However, if banks and other private sectors increase the outstanding balance of the current accounts at the BOJ and cash holdings, cash in circulation slips out of the credit creation process, and the money multiplier declines.
In order to examine factors that caused fluctuation of the money multiplier, the factors were divided into the reserves/deposits ratio of the financial sector, the cash/deposits ratio of the financial sector, and the cash/deposits ratio of the non-financial sector (See Figure 1-3-6). The money multiplier declines (rises) when the reserves/deposit ratio of the financial sector rises (declines), when the cash/deposits ratio of the financial sector rises (declines), and when the cash/deposits ratio of the non-financial sector rises (declines).
The money multiplier has been on a long-term downward trend. This is mainly due to a rise in the cash/deposits ratio of the non-financial sectors, such as households and firms. The preference for cash in portfolios has strengthened against the prolonged low interest rates.
During the 1999 - 2000 period and after 2001, the money multiplier declined much steeper than its long-term downtrend. This is because both the cash/deposits ratio and the reserves/deposits ratio of the financial sector rose. The decline during the 1999 - 2000 period can also be attributed to a fall in the opportunity costs of holding liquidity and to moves against the Y2K problem. The decline after 2001 can also be attributed to the fact that the monetary base supplied by the quantitative easing was not fully used in the process of credit creation, as well as to moves related to the proposed abolition of full deposit guarantee and management integration. Behind all these is the decline in bank loans. Bank loans decreased because (i) the corporate sector has been repaying debts to banks as part of its efforts to dissolve excess debts, and (ii) the banking sector has been reducing loans to risky corporations due to their reduced capacity to accept risk.
Behind the low growth of money supply, the credit creation function did not work fully due to the strong preference for cash in portfolios and the decline in bank loans.
Figure 1-3-6 Changes in Money Multiplier
Money supply and GDP
Next, let' s look at the relationship between money supply and GDP.
It is generally believed that there is a strong correlation between money supply and GDP. This is because if financial institutions supply deposits through financing or purchase of bonds, it increases business investments by an increase in lending and a decline in interest rates, and stimulates economic activity. At the same time, on the demand side of money, as a result of the increased economic activity, it increases the demand for deposits as a means of settlement (transactions demand).
A study of the long-term relationship between money supply and GDP shows that it was stable until around 1997. However, such a stable relationship has not been observed since 1998(87). During this period, money supply kept growing, albeit marginally, while Real GDP sometimes posted negative growth.
Behind this, money demand except for transaction demand increased. It was brought about by such factors as the financial unrest in the autumn of 1997, the so-called Y2K problem in the late of 1999, and the deterioration of fund-raising conditions for low-rated corporations in 2000 and in late of 2001. In addition, with interest rates staying at extremely low levels, there was a shift to liquid deposits due to the maturity of huge amounts of postal savings time deposit from 2000 to 2001 and trust funds' fall below par due to the business failure of Enron in the autumn of 2001.
As just described, it can be said that the lack of Real GDP growth, despite the increased money supply, has been due to the increase in money demand except for transaction demand.
Quantitative easing and depreciation of yen
The effect of the quantitative easing cannot be verified by the main transmission mechanism of the monetary policy (the route via bank lending). This is because bank lending is decreasing, the growth of money supply is low, and Real GDP growth is stagnant, despite the high level of the outstanding balance of current accounts at the Bank of Japan and the high growth rate of the monetary base.
When we expect the "portfolio rebalancing" effect of the quantitative easing, we do not, of course, necessarily expect only its normal spillover effects. What is expected of this effect is that it would create an expectation that an increase in no-risk, no-return assets of the outstanding balance of current accounts at the Bank of Japan will cause a change in asset management as seen from financial institutions and from the economy as a whole and lead to an increase in higher-risk, higher-return assets. Therefore, higher-risk, higher-return assets are not limited to loans. Rather, there are various routes through which the effect of the monetary policy is transmitted other than an increase in loans.
Among the routes other than an increase in lending is, for example, currency depreciation. That is to say, an increase in no-risk, no-return assets of the outstanding balance of the current accounts at the Bank of Japan would increase demand for external assets and this in turn would cause currency depreciation.
In fact, the yen' s exchange rate vis-à-vis the U.S. dollar stood at 116.4 yen in February 2001, and shortly before the adoption of the quantitative easing, began to depreciate, reaching 133.5 yen one year later in February 2002. This suggests that the quantitative easing may have been effective in reducing the value of the yen.
In order to examine the effect of the quantitative easing, we have estimated the function that explains the movement of exchange rates since 1990(88). According to the estimation, the growth rate of monetary base including the outstanding balance of the current accounts at the Bank of Japan, is statistically significant. This suggests that the depreciation of the yen may have been caused by the effect of the quantitative easing(89).
Of course, various factors affect the movement of exchange rates. Such factors may have caused the depreciation of the yen. The example mentioned above is the movement of long-term interest rates, which is believed to have a big impact on exchange rates. In the United States, interest rates fell in the middle of FY2001, reflecting increased uncertainties about the U.S. economy in the wake of the September 11 attacks, but rose in the second half of FY2001 because of rising expectations of an early recovery of the U.S. economy. Since the yen depreciated further from the end of the calendar year to the end of the fiscal year, it can be attributed to a rise in the expected earnings rate of dollar-based assets. Moreover, since overseas portfolio investment was low from the end of the calendar year to the end of the fiscal year, it cannot be said that the increases in the outstanding balance of current accounts at the Bank of Japan and in monetary base directly brought about "portfolio rebalancing during the period." However, since overseas portfolio investment increased before and after the period and the yen was on a weak trend after 2001, the quantitative easing may have had its effect.
The quantitative easing may have had a positive impact on the real economy through its effect of yen' s depreciation.
Figure 1-3-7 Change of Real Exchange Rate and Relative Gap of Monetary between Japan and U.S.
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