Annual Report on the Japanese

Economy and Public Finance

2003-2004

- No Gains Without Reforms IV -

July 2004

Cabinet Office

Government of Japan


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   Section 5 The Progress in Structural Reform in Fiscal Policy and Financial Systems
   
    Under the severe state of public finance, the government has been advancing efforts to restrain expenditure with the objectives of achieving a primary surplus for central and local governments in the early 2010s, and until FY2006 keeping the ratio of general government expenditure to GDP from exceeding its level in FY2002. Hence, the expected fiscal deficit (net lending) to GDP in FY2004 is about 6.9%, which is slightly lower than the estimate of 7.7% in FY2003. However, the level of fiscal deficit for central and local governments itself remains high. Also, the debt of the government is expected to continue to increase, and it is expected that the ratio of long-term debt of the central and local governments to GDP will exceed 140% at the end of FY2004. This would be the highest level of fiscal deficit among the developed economies. Against this backdrop, various fiscal structural reforms are being advanced, and one of the most important tasks is to implement efforts to curb the increase in social security costs, which account for a substantial portion of the government expenditure due to the aging of population. Meanwhile, in terms of the policy for the financial system as well, efforts for financial normalization including disposal of non-performing loans are being advanced with the objective of addressing structural issues such as trade credits and bank lending that have emerged since the second half of the 1990s against the backdrop of financial transaction curtailment in the private sector. In this section such initiatives for structural reform in public finance and financial systems and their status of progress are examined.
   
1. Trends in Government Finances and Outlook
   

    Due to the advanced aging of society, pressure to increase fiscal outlays has increased, and against this backdrop, the government has been advancing efforts to restrain its expenditure with the objectives of achieving a primary surplus for the central and local governments in the early 2010s, and until FY2006 keeping the ratio of general government expenditure to GDP from exceeding its level in FY2002 (Figure 1-5-1). As a result, the deficit in terms of primary balance (fiscal balance that deducts "expenditures excluding principal and interest payment related to past debts" from "revenues from tax, etc. excluding borrowings") for the central and local governments is projected to decrease slightly, as the ratio of the deficit against GDP is expected to drop to about 5.5% in FY2003 and to about 4.5% in FY2004. An outline of the trends in fiscal balance in the last few years is given and the issue of whether the balance has improved is examined.
Figure 1-5-1 Trends in the Ratio of General Government Expenditure to GDP

Government fiscal balance deteriorated slightly in FY2002
    An retrospective examination of the trends in the fiscal balance of the central and local governments up until FY2002, illustrated by actual results, reveals that in the period that covers FY2000 and FY2001, the ratio of the deficit to GDP fluctuated between the 6.5-7.0% range and the 7.0% range, but in FY2002 the fiscal balance deteriorated significantly as the deficit ratio to GDP settled at 8.0% (Table 1-5-2). Almost the same trends are observed for the general government balance. In terms of the general government expenditure, the increase in current expenditure, which includes government consumption and social security, etc., was marginal in the FY2001-FY2002 period, and reductions in investment spending continued. As a result, overall expenditure on the whole remained almost flat. Meanwhile, for the general government revenue, the tax revenue from interest earnings significantly decreased in the FY2001-FY2002 period following the maturing of postal savings, as a result of which overall tax revenue dropped by more than six trillion yen. This became one of the factors behind the deterioration of the fiscal balance in FY2002. Almost the same trend is observed for the primary balance of the central and local governments. The deficit deteriorated from 4.1% in FY2001 to 5.6% in FY2002. An examination of the balance by sector reveals that deterioration in the fiscal balance of the central government accounts for the overall deterioration of public finance in FY2002.
Table 1-5-2 Fiscal Balance By General Type of Government
    As for the balance of social security funds, which is included in the general government fiscal balance, but not in the balance of the central and local governments, it had consistently been in surplus in the past, but following the increase in pension benefit spending due to the advancement of the aging society, from FY2001 onwards, the balance has been in the red. Such deficits in the social security funds are partly handled by essentially dissolving pension reserves.
   
Central and local government budget deficit improves slightly in FY2003, general government deficit remains almost flat
    The fiscal balance of the central and local governments in FY2003 is expected to improve slightly from FY2002 with a projected deficit ratio to GDP of about 7.7% (Table 1-5-3). The general government deficit is expected to stay almost flat in the FY2002-FY2003 period. An examination of the major items in the general government expenditure based on the government's economic forecast and the budget shows that the final consumption expenditure of the government is expected to increase only slightly from the previous fiscal year, but this is mostly due to the 2% cut in salaries of national public servants. As for public investment, a significant decline is expected to continue, and, according to the projected result of the government's economic forecast, nominal public investment is projected to drop by about 10% in FY2003 (note that public corporate investment is not included in general government spending although it is included in public fixed capital formation). Social security benefits, on the other hand, are expected to continue to grow along with the advancement of the aging society. Excluding the budget related to mutual aid benefits, for which there are no clear detailed data, an approximately 2% increase in social security benefits from the initial budget for the previous fiscal year is expected in FY2003. However, due to the indexation of pensions, benefits are being curbed in line with the decline in prices (0.9%), and the increase in benefits has slowed down from the period before FY2002 when there was a freeze on indexation. Based on the above developments, the size of the overall general government expenditure in FY2003 is projected to slightly shrink from the previous fiscal year and settle at about 37% of GDP. In addition to the prioritization of the budget allocation, the curbing of expenditure reflects the government's policy target aimed at effectively curbing general accounts and general expenditures of the central government below the levels of the previous fiscal year, and the continued review of expenditures of local governments.
    The general government revenue, on the other hand, is projected to decline, albeit slightly, below its level of the previous fiscal year, due to the advanced tax reductions. A breakdown of revenue shows that, regarding the tax revenue of the central government, revenue from income tax is expected to drop due to a downturn in income, and revenue from corporate tax is projected to decline slightly because of the tax revisions despite the increase in corporate profitability. As for the impact of FY2003 tax revisions on the tax revenue of the central government, it is projected that cuts in the corporate related taxes on IT-related capital investments and research and development (R&D) will result in a drop in revenue of 1.3 trillion yen, changes in inheritance and gift taxes and changes in financial and securities tax systems will result in about 100 billion yen drops each, and revisions of the land tax system will reduce tax revenue by approximately another 200 billion yen. Raising of liquor and tobacco taxes, on the other hand, will replete tax revenue by about 160 billion yen, so the overall reduction of tax revenue due to the FY2003 tax revisions is expected to amount to about 1.5 trillion yen (Appended Table 1-22).
Table 1-5-3 State of Public Finance

Government fiscal balance forecast to improve in FY2004
    The government compiled the FY2004 budget maintaining the policy of effectively restraining the size of the general account expenditure and general expenditure below their levels in the previous fiscal year. It is projected that the tax revenue of the central and local governments will slightly improve under the positive influence of economic recovery and tax revisions. Against this backdrop, the fiscal deficit of the central and local governments is projected to decline by about 0.8 percentage points in GDP for FY2003-FY2004 and the ratio of primary deficit to GDP is expected to fall from about 5.5% in FY2003 to about 4.5% in FY2004. Also, the fiscal deficit of the general government to the GDP is projected to decline, albeit slightly, to about 7.5%. As for the major expenditure items, the rate of increase in government final consumption is projected to slightly rise by about 1.8% from the previous fiscal year, and social security benefits will continue to increase in the 3.0% range. As for public investment, judging from the change in public fixed capital formation in the government's economic outlook, it is expected to remain on its drastic downward trend decreasing by 12%. Regarding the impact of system changes in expenditure, etc., the continued indexation of pension benefits contributed to a decrease of 0.3% of the benefit in line with the rate of deflation. Medical treatment fees and drug prices, etc. fell by 1%, contributing to curbing government expenditure. As will be observed later, other expenditure is also projected to be curbed in the course of advancing the reforms of the fiscal relationship between the central and local governments. As for the revenue side, the FY2003 tax revisions are planning continuous tax cuts, including the abolishment of the surcharge portion of the special spousal exemption from income tax and the reduction of the special measures for small and medium enterprises (SMEs) regarding consumption taxes (Appended Table 1-22). Against this backdrop, a slight increase is projected in the tax revenue of the central and local governments reflecting the economic recovery.
   
Trends in the general government's cyclical fiscal balance and structural fiscal balance
    Changes in fiscal deficits can be divided into cyclical balance and structural balance. Cyclical balance represents fluctuations in fiscal balances due to the cyclical movement of the economy, which leads to increases/decreases in tax revenue and expenditure. Structural balance is calculated by subtracting cyclical balance from actual balance.
    Dividing, under certain assumptions, the change in the general government balance into cyclical deficit and structural deficit, followed by an examination of the structural deficit shows that the structural deficit slightly expanded in FY2001-FY2002 even if it is adjusted for the impact of temporary increases in tax revenue due to maturing of postal savings, and it remained almost flat in FY2003, and is expected to decrease, albeit slightly, in FY2004 (Figure 1-5-4).
Figure 1-5-4 General Government Cyclical and Structural Budget Balance

Future risks to public finance
    As observed above, the fiscal balance and primary balance of the central and local governments are projected to improve. However, what would be a major risk to this scenario, which could hamper the progress in fiscal reconstruction? One possibility is a rise in long-term interest rates. If long-term interest rates did rise significantly as the economy recovers, the outstanding amount of government bonds issued each year would reach enormous proportions, and the rise in interest payment costs could exceed the increase in tax revenue due to the economic recovery, causing fiscal balance to deteriorate.
    The long-term debt of the central and local governments as of the end of FY2004 will reach about 719 trillion yen, and of which about 483 trillion yen will be the outstanding balance of ordinary government bonds. In FY2004, new government bonds amounting to about 37 trillion yen and refinanced bonds amounting to about 84 trillion yen, which are summed up to a total of about 121 trillion yen (excluding Fiscal Loan Fund Special Account Bonds), will be issued (Figure 1-5-5). A rise in interest rates would not have any impact on interest payments for government bonds already issued, but it will inevitably impact newly issued bonds. Also, since a significant portion of previously issued bonds also gets refinanced every year, the impact of the rise in interest rates on the fiscal balance will grow from year to year. According to the Estimation of Impact of FY2004 Budget on Expenditure and Revenue in the Following Fiscal Years compiled by the Ministry of Finance, if, compared to the standard case, interest rates increase by one percentage point from 2% to 3%, government bond costs would rise by 1.2 trillion yen in FY2005, and by about 3.7 trillion yen in FY2007.
Figure 1-5-5 Amount of Government Bond Issues

2. Expenditure Reform

   
Status of progress of budget system reform and expenditure reform, etc.
    Revisions of the modalities for budget formulation and efforts for streamlining of expenditure have been launched by all major developed countries since the 1990s. Against this backdrop, Japan as well has been steadily implementing similar budget and expenditure reforms in the past few years (Table 1-5-6). Here an outline of the fiscal reform initiatives of Japan so far is presented, comparing them to the experiences of other developed countries.
Table 1-5-6 Major Expenditure Reforms Since FY2002

(1) Basic policies for medium-term fiscal management
    The United States, EU member countries and other developed countries have adopted certain fiscal rules in fiscal management and fiscal restructuring since the 1990s(21). In Japan, the government announced in the Structural Reform and Medium-Term Economic and Fiscal Perspectives (so-called "Reform and Perspectives") the objective of achieving a primary surplus for the central and local governments in the early 2010s, by keeping the ratio of general government expenditure to GDP until 2006 from exceeding its level in FY2002. Based on such policies, in formulating the FY2003 and FY2004 budgets, the government aimed to effectively curb both the general account expenditure and the general expenditure below the levels for the previous fiscal year. The OECD (2002) points out that, compared to policies directly aiming for fiscal balance, policies that aim to curb the scale of government expenditure have the advantage of being less restrictive to economic growth as the government cannot easily depend on tax increases in order to achieve fiscal restructuring; yet on the other hand, in some cases, setting a target on expenditure alone is not enough to ensure fiscal stability. Thus, it is necessary to carry out fiscal restructuring through well-balanced measures with the objective of improving the primary balance.
   

(2) Reform of the budget formulation process
    Improving the quality and transparency of budgets is an important step in the process of advancing structural reform in fiscal policy, and the government is building a budget formulation process that can fulfill the accountability of the government to the people. As for the top-down approach in budget prioritization and streamlining, the Council on Economic and Fiscal Policy (CEFP) has established mechanisms in the past few years with regard to the formulation of the "Basic Policy for Reform" and other policies, whereby the Prime Minister and ministers in charge investigate and deliberate policies and basic guidelines for budget formulation, and thus their leadership contributes to budget prioritization and streamlining (Appended Figure 1-23). Also, the OECD (2004) points out that introduction of a process for formulation of multiple-year budgets is an efficient measure for avoiding postponement of the fiscal burden and for restoring fiscal soundness for the medium term. Also, it is necessary to clarify further multiple-year guidelines for major expenditure areas. Presently, model projects have been experimentally implemented as part of a budget formulation reform to realize the accountability of the government to the people.
   
(3) Project and policy evaluation
    Since the enactment of the Government Policy Evaluations Act (Law No. 86, 2001) in April 2002, every government ministry and agency has been making efforts to proactively reflect the results of policy evaluations in their budget requests. Also, each government ministry and agency submits, together with its budget requests, its Reports on Policy Goals and Objectives, which is a record of policy evaluation results(22), and in the budget formulation process, requests and demands are closely examined using such reports as reference material. However, in many cases it is difficult to apply such policy evaluations, as they are quite often limited to qualitative assessments, and do not sufficiently ensure objective and neutral judgment. Therefore, it is necessary to quantify such evaluations even further in future to ensure their objectivity, and to improve their accuracy.
    Furthermore, budget implementation surveys were launched from FY2002 onwards, whereby persons in charge of screening budget requests visit the worksite of different projects and check whether the budgets are being implemented in an efficient and effective manner. In FY2003, 51 projects, including 20 special accounts projects were surveyed, as a result of which 49.2 billion yen were reflected in the FY2004 budget.
   
(4) Transparency of public finance
    Advancing reforms with the objective of keeping clear track of public finance, including not only general accounts but also special accounts, is extremely important from the perspective of improving the transparency of public finance. Toward that end, various reforms are being promoted. Special accounts are being revised in line with the proposal of the Fiscal System Council of November 2003 (Appended Table 1-24), and apart from the creation and disclosure of new explanation materials on expenditure contents aimed at strengthening accountability, efforts are being made to ensure disclosure of information in an easy-to-understand manner. Part of such efforts is the initiative for "New special accounts financial statements" that utilize corporate accounting methods. As for the Fiscal Investment and Loan Program, which is an integral part of the government's fiscal policy, the modifications of the fundraising process and the reform of special public institutions, which use the fund in fiscal investments, have been implemented. In addition, the government is implementing a policy cost analysis of projects that utilize fiscal investments and loans, and is disclosing their policy costs, which indicate the amount of subsidies envisioned for future investments from the government and conditions and costs for use of investments (opportunity costs) calculated under certain premises(23).
   
(5) Introduction of result-oriented budget formulation methods, principles of competition and price mechanisms
    With regard to result-oriented budget formulation methods, ten model projects were experimentally introduced in the FY2004 budget (Appended Table 1-25). It is stipulated that such model projects should (i) quantitatively demonstrate the policy objectives that will be realized through the allocated budgets, (ii) carry out flexible budget implementation tailored to the nature of the project in order to achieve the outlined objectives in an efficient manner, and (iii) carry out, after the projects are implemented, strict evaluations on the status of achievement of the objectives, and reflect the results of these evaluations in the formulation of the budget for the next fiscal year. In conjunction with these efforts, the initiative of "policy groups" was also launched under the FY2004 budget with the objective of realizing policy goals that extend across multiple government ministries and agencies. Policy groups aim to implement measures that cut across various ministries, and to maximize the effects of the budget by incorporating it in different policy initiatives including regulatory reforms and others.
    With regard to government procurements and public works, Japan has adopted a framework based on the WTO agreements(24), but in terms of implementation, there are still many cases, in which legal actions pursuant to the Antimonopoly Act are taken to deal with bid-rigging, making it necessary to further improve the implementation aspects of government procurements and public works(25). As for external outsourcing of public services and utilization of private-sector enterprises under the private financial initiative (PFI), this issue is discussed in more detail in Chapter 2, but these trends are gradually spreading through local governments. Measures for expansion of consumers' choice through the introduction of vouchers which has already been introduced in some developed countries are still almost unheard of in Japan. However, the education and training benefits is thought to exercise functions close to those of the voucher system by providing persons insured under the Employment Insurance (or persons who were insured in the past) the opportunity to choose education and training facilities,(26).
   
Promotion of the reform of the fiscal relationship between the central and local governments
    The reform is aimed at advancement, in an integrated manner, of reform of state subsidies, reform of local allocation taxes, and review of the allocation of tax revenue sources, including the transfer of tax revenue sources to local governments. The goals of such reforms are, by significantly enhancing the power and responsibilities of local governments and increasing their discretion in handling revenue and expenditure, to first expand the range of administrative services that local governments can choose to implement at their own initiative and in an independent and efficient manner truly meet the needs of the people, and further to enable the creation of a simple and efficient administrative and financial system that encompasses the central and local governments. Toward this end, the following specific reform measures were outlined in the Basic Policies 2003:
(1) With regard to the reform of state subsidies, abolish and reduce state subsidies to local governments by around four trillion yen through FY2006.
(2) With regard to the reform of local allocation taxes, review and curtail overall function of local allocation taxes of guaranteeing fiscal resources, review expenditure of local governments and curb the total amount of local allocation taxes.
(3) As for the review of the allocation of tax revenue sources, including the transfer of tax revenue sources to local governments, regarding projects now covered by state subsidies that are to be abolished, transfer tax revenue sources to local governments for those projects that further need to be implemented with local governments as the main players. In doing so, the transfer of tax revenue sources will be implemented on the basis of replenishing main taxes. For the transfer of tax revenue sources, transfer revenues equivalent to around 80% of the subsidies being cut, taking into account the nature of subsidies, etc. For mandatory projects, full amounts of necessary expenses will be covered through the transfer of tax revenue sources, but only after thorough efforts to bring greater efficiency into those projects. Also, expand the right to autonomy of local governments on taxation.
   

    Under the policies mentioned above, state subsidies to local governments were abolished or reduced by one trillion yen in FY2004. Specifically, subsidies amounting to 244 billion yen, of which 166.1 billion yen for child-care expenses (including subsidies for management of public day care centers) were converted to unrestricted fund (transferred to financial sources for uses not specified) and state subsidies for compulsory education (retirement allowances and child allowances) (230.9 billion yen) were tentatively converted to unrestricted fund, while subsidies related to public works projects were reduced by 452.7 billion yen and a subsidy for urban development (133 billion yen) was newly established (Table 1-5-7). Also, the initiatives for converting subsidies to unrestricted fund were accompanied by transfer of tax resources (424.9 billion yen) through introduction of a local transfer tax on income in line with the reforms of subsidies implemented in FY2003 and FY2004. In addition, by establishing a transfer (230.9 billion yen) intended for future shift of tax resources with regard to state subsidies for compulsory education (retirement allowances and child allowances). In all, the government implemented measures worth a total of 655.8 trillion yen(27). Also, with regard to local allocation taxes, the review of expenditures in local fiscal plans resulted in an approximately a 1.5 trillion yen reduction from the previous fiscal year of the total amount of expenditures, with a 9.5% year-on-year reduction of investment expenses (for individual projects), and a 1.9% reduction in salaries and related expenses. As a result, the amount of local allocation taxes dropped by approximately 1.2 trillion yen from the levels of the previous fiscal year. Furthermore, with regard to the enhancement of the right to autonomy on taxation for local taxes, apart from reviewing the definition of standard taxation rate and expanding the freedom for setting taxation rates, the government implemented various system revisions, including curbing of the central government's involvement in modification of taxes not stipulated under law.
Table 1-5-7 Subsidies, etc. for Local Governments (General Accounts and Special Accounts Totals)
    The Basic Policies for Economic and Fiscal Policy Management and Structural Reform 2004, adopted by Cabinet decision in June 2004, stipulate that the reform blueprint, which will be clarified in the fall of 2004 and be determined by the end of the year, will incorporate a schedule for reform of state subsidies amounting to about 3 trillion yen in FY2005 and FY2006, contents of transfer of tax revenue sources and directions of the reform of local allocation taxes. The "Basic Policies 2004" state also that the government will aim to transfer tax revenue sources worth approximately 3 trillion yen to local governments. As a step toward implementation of such transfer, the central government will require local governments to present specific proposals for reform of state subsidies and will carefully examine these proposals.
   
Pension reform toward establishment of sustainable system
    Review of the pension system is implemented every five years, but in the years since the system was last amended in 2000, the state of pension finance has deteriorated due to certain changes in Japan's society and economy. Specifically, birthrates are declining and the society is aging much faster than projected, interest rates remain low against the backdrop of continuing deflation trends, and the growth in wages remains significantly below the expected levels (Figure 1-5-8). Furthermore, under the severe economic conditions, the freeze remained on the increase in contribution to pension insurance, which should be revised once every five years, and it was still unclear as to when the ratio of state contributions to basic pensions would be increased to one-half.
Figure 1-5-8 Premise of the Pension System Reform
    Because of the fast decline in birthrates and the aging of the population, as well as the slowdown in real wage growth rate, an even greater contribution will become necessary unless the benefit rates are modified(28), but if the price effect of labor supply (the effect of decline in incentive to work due to decline in after-tax wage rates) comes to exceed the income effect (the effect of increasing labor hours in order to prevent decline in pre-tax income), then the excessive burden of insurance premiums will destroy motivation for labor, and might have a negative impact on the economic growth (Appended Figure 1-26).
    Against this backdrop, the government intends to introduce the following measures in the next revision of the pension system (Figure 1-5-9):
(1) Establishment of fixed ceiling on insurance premium levels for Employees' Pension and National Pension and introduction of mechanisms for automatic adjustment of benefit levels within the scope of the insurance premium revenue.
(2) Stepwise increase in the state contribution ratio to basic pensions to one-half by 2009.
(3) Switch from the formula for revising benefit levels in line with per capita income and inflation rates to a formula called macroeconomic indexation within a specified benefit level adjustment period(29).
(4) With regard to pension reserves, switch from the formula for always keeping a certain amount of reserves in order to maintain equilibrium in pension finance for an indefinite period of time in the future (permanent equilibrium formula), to a formula which aims to maintain balance for a period of about 100 years (limited equilibrium formula).
Figure 1-5-9 Financial Impact of 2004 Pension System Reform
    Such measures are expected to result in curbing the final insurance ratio to 18.3% for Employees' Pension and 16,900 yen for National Pension (as of 2004) and raising the insurance premium levels annually until FY2017.
    The Ministry of Health, Labour and Welfare made an estimate of the gap in insurance premium revenue and total amount of benefits as calculated under the formula for fixed insurance premium levels described above and the existing formula for maintaining benefit levels in future, taking the Employees' Pension as a case study. According to the estimate, the Ministry expects that the total amount of insurance premium income under the new system will drop below the amount under the current system after FY2017 when the final premium rates are reached and that the total amount of benefits will drop below the current system because of the adjustment of benefits carried out through macro-economic indexation (Appended Figure 1-27). Other financial estimates show that since the limited equilibrium formula will be used, pension reserves will start declining from around FY2040 and by FY2100 there will be reserves left to cover only about a year's worth of expenditure. As for the future distribution of the premium burden and pension benefits among generations, picking up the Employees' Pension as a case study, the proportion of the pension benefit amount to insurance premium is 8.3 times for a person of age 70, and is declining to 4.6 times for 60-year old persons, 3.2 times for 50-year old persons, and 2.3 times for 20-year old or younger persons (Appended Table 1-28). This generation gap in the proportion of pension benefits to premiums was triggered by the following two factors: first, when the current pension system was established, premiums were set low levels matching the individual's ability to shoulder burden at that time, and second, improvement of benefits in line with the increase in prices and wages was carried out at the expense of the younger generations, who will have to shoulder the burden of such measures.
   
3. The Problem of Domestic Funds Flow and the Progress of Financial Reform
   

Curtailment of financial transactions and the background of this trend
    Finances and economic activity are two sides of the same coin. When economic activity declines financial transactions also dwindle. Therefore, when the economy faces structural problems, the subsequent slump in economic activity will be reflected in the status of financial transactions as well. On the other hand, smooth financial transactions increase the efficiency of finance utilization in the overall economy by maintaining balance in household budgets and corporate finances, and thus stimulate economic activity. Therefore, problems in the financial system will bring pressure upon economic activity.
    Here, attention is paid to the issue of the macroscopic financial intermediary function in order to clarify the curtailment of financial transactions that started in the second half of the 1990s and the structural problems in the background of this process, as well as to confirm the status of progress of various initiatives aiming for financial normalization.
    First, in order to understand the problems faced by Japan's financial system, the period from FY1991 to FY2002 is split into first half (FY1991-FY1996) and second half (FY1997-FY2002), and explored the net average status of financial transactions after off-setting financial investment and fund-raising. Compared with the first half, the second half had the following characteristics (Figure 1-5-10).
Figure 1-5-10 Changes in Financial Transactions in Japan
    First, financial transaction amounts have dwindled substantially.
    Second, on the financial investment side, trade credit amounts started to decline against the drop in financial transactions, and the presence of public-sector financial institutions is increasing, compared to that of private-sector financial institutions. On the other hand, almost no changes were observed in transaction amounts for direct finances such as shares and other equities.
    Third, on the fund-raising side, the financial procurement amounts of household budgets and corporations drastically declined, and corporations are using finances to repay debts. On the other hand, the government is increasing procurement amounts.
    Looking at this situation of financial transactions from the viewpoint of flow of funds among domestic economic players, the following characteristics of the second half as compared to the first half come into focus (Figure 1-5-11).
Figure 1-5-11 Movements of Funds among Domestic Economic Players
    First, following the decrease in the financing surplus of household budgets, the amount of funds supplied to private financial institutions and the general government is also decreasing.
    Second, corporations moved from shortage of funds to financing surplus, triggering a reflux of funds from corporations to private financial institutions.
    Third, the government's shortage of funds increased, and the amount of credits provided from private financial institutions to the general government is increasing.
    Thus, against the backdrop of the dwindling financial transactions in the private sector from the mid-1990s onwards, the pattern of domestic flow of funds has changed from the regular flow of funds from households to corporations via private financial institutions to a flow of funds from households and corporations to the general government via private financial institutions. This means that the fund distribution and risk allocation functions that the private sector financial system is expected to execute are declining. The decline is triggered by problems such as the significant amount of non-performing loans incurred by banks due to the collapse of the bubble economy and the subsequent slump in economic activity and excessive corporate debt. The government also held vigorous deliberations on the preferable modalities of public finance and the corporate sector, taking into consideration the impact of the curtailment of financial transactions by the private sector on the resource allocation function of the financial capital markets. These deliberations are incorporated in the fiscal investment and loan reform, reform of special public institutions and privatization of postal services.
    Next, the state of improvements in both banks and businesses toward the recovery of financial intermediary functions in Japan will be examined, followed by a description of the status of initiatives for reforms in the public finance and corporate sectors.
   
Status of progress in disposal of non-performing loans by major banks
    Japanese private financial institutions have established close relations with corporations, providing them with household funds via lending and holding of securities. Of such private financial institutions, banks, and especially the major banks, hold more than half of the total balance of lending to corporations, and have come to play a central role in the financial system. The increase in non-performing loans following the collapse of the bubble economy and the subsequent economic slump greatly reduced the risk tolerance of banks, while the process of reduction of excessive debt made it very difficult for corporations to implement proactive corporate management. These developments in the financial system, which is highly dependent on banks, further deepened the stagnation in economic activities.
    The Financial Services Agency announced its Program for Financial Revival in October 2002, stating that it will strive to normalize the non-performing loans problem of major banks by halving by the end of March 2005 the ratio of major banks' non-performing loans of 8.4% as of the end of March 2002. Examining the status of progress toward reaching the goal of halving the non-performing loans ratio of the eleven major banks on the basis of March 2004 financial statements(30), the following specifics can be observed (Figure 1-5-12).
    First, the balance of non-performing loans of major banks (classified assets based on the Financial Reconstruction Law) decreased from 20.2 trillion yen in the previous year to 13.6 trillion yen, and the ratio of non-performing loans (to total credit) dropped from 7.2% to 5.2%.
Figure 1-5-12 Improvements in Banks' Non-performing Loans
    Second, looking at the breakdown of non-performing loans by type, "doubtful" loans and "bankrupt or de facto bankrupt" loans which fall under the category of loans to borrowers classified as "in danger of bankruptcy or worse" were reduced by 2.1 trillion yen from the previous year, and "special attention" loans were also reduced by 4.5 trillion yen from the previous year.
    Third, the non-performing loans disposal losses required for the disposal of non-performing loans dropped from 5.1 trillion yen to 3.5 trillion yen on a year-on-year basis, and the core banking profits, or the profit from core businesses, remained almost flat, declining only slightly from 4.1 trillion yen to 3.9 trillion yen.
    All developments described above can be summed up as follows: the profit of main banks remained flat, while the disposal of non-performing loans advanced further (as of the end of March 2004) and as a result the non-performing loans disposal losses were kept below the level of core banking profits. Therefore, according to the March 2004 financial statements, the financial status of the major banks can be evaluated as progressively improving.
   
The challenge of the non-performing loans problem at regional banks
    What is the status of progress in the disposal of non-performing loans of banks other than the major banks? Next, the state of affairs of regional banks will be examined(31). Looking at the March 2004 financial statements of regional banks, the following characteristics attract attention(32) (Figure 1-5-12 (1)).
    First, the balance of non-performing loans of regional banks (classified assets based on the Financial Reconstruction Law) decreased from 14.7 trillion yen to 11.7 trillion yen on a year-on-year basis, and the ratio of non-performing loans (to total credit) dropped by 1.3 percentage points from 7.8% to 6.5%.
    Second, looking at the breakdown of non-performing loans by type, "doubtful" loans and "bankrupt or de facto bankrupt" loans which fall under the category of loans to borrowers classified as "in danger of bankruptcy or worse" were reduced by 1.9 trillion yen from the previous year, and "special attention" loans were also reduced by 1.0 trillion yen from the previous year.
    Third, the non-performing loans disposal losses dropped from 1.6 trillion yen to 1.1 trillion yen on a year-on-year basis, and the core banking profits remained almost flat, declining from 1.9 trillion yen to 1.8 trillion yen on a year-on-year basis.
    Based on the above described developments, the evaluation of the status of regional banks can be summed up as follows: despite the fact that their profitability remained flat, they advanced the disposal of non-performing loans and their overall financial state improved.
    With regard to the problem of non-performing loans faced by small- and medium-sized and regional financial institutions, the Financial Services Agency released in March 2003 its Action Program Concerning Enhancement of Relationship Banking Functions. The Action Program stipulates that the government will strive to strengthen the functions of relationship banking, toward solving the non-performing loans problem(33). However, based on specifics of non-performing loans of small- and medium-sized and regional financial institutions, etc., the Action Program does not specify numerical values corresponding to the objectives set for major banks. This is because the options for methods for drastic corporate revitalization and the possibilities for utilization of human and other resources are limited in regional economies, and also because advancing prompt disposal without creating an environment to ensure the smooth mobility of employment and utilization of human resources, etc. could trigger a drastic increase of unemployment and have a negative impact on regional economies.
    For instance, looking at the breakdown of non-performing loans of regional banks by type, "doubtful" loans and "bankrupt or de facto bankrupt" loans which fall under the category of loans to borrowers classified as "in danger of bankruptcy or worse" occupy 67.3% of the entire amount of non-performing loans, which is 48.9% more than the same share for major banks (Figure 1-5-13). However, this discrepancy between major banks and regional banks is not a result of a postponement of the problem, but rather a reflection of the specifics of regional economies, etc. Therefore, it is important to advance the disposal of non-performing loans in a manner tailored to the specifics of each region.
Figure 1-5-13 Breakdown of Non-performing Loans by Type
    This means that even regional banks should implement efforts for accelerating the disposal of non-performing loans in order to maintain their own management soundness and to ensure sustainability. However, in doing so, banks will have to continue to strengthen their profitability as a step toward preventing the occurrence of new non-performing loans, through enhancing relationship banking functions, while taking into consideration the actual situation in each region.
    Furthermore, against the backdrop of the required enhancement of relationship banking functions, it is possible that the regional economies are not able to respond to the structural changes, and as a result the share held by low-yield industries in the regional economies will hover at relatively high levels. It has also been pointed out that under such conditions, regional banks, which are implementing community-based business activities, are shouldering excessively high costs in order to answer the expectations of the regional economies.
    Here, in order to clarify this point, the simulated average profit rate of possible borrowers at all banks and regional banks are examined by weighting the profit rate (ordinary profit of sales) of businesses in all industries by scale of business against the lending ratio of all banks and regional banks by industry by scale of business and the changes in rates of return from borrowers both at all banks and regional banks are compared. The results stress the following specifics (Figure 1-5-14).
Figure 1-5-14 Simulated Profit Rate of Possible Borrowers from All Banks and Regional Banks
    First, since the end of the 1990s, the rate of return of possible borrowers both at all banks and at regional banks has been on the upturn, reflecting the overall trend for improved profitability due to the low interest rates policy and the initiatives for elimination of excessive debt and corporate restructuring, etc.
    Second, the gap between the rate of return of possible borrowers at all banks and the rate of return of borrowers at regional banks has been expanding during the same period. This reflects the difference in the lending structure by industry and the lending structure by scale of business for possible borrowers at all banks and at regional banks.
    Regarding the lending structure by industry, compared with possible borrowers at all banks, possible borrowers at regional banks occupy a smaller share of high-profit industries such as real estate, and transport and telecommunications, and a larger share of low-profit industries such as construction and services. Therefore, their rate of return is relatively lower.
    As for the lending structure by scale of business, given the facts that the profit rates of small- and medium-sized enterprises and micro-enterprises are lower than those of large enterprises, and that the share occupied by small- and medium-sized enterprises in regional economies is larger than that of large enterprises, the rate of return of possible borrowers at regional banks is low. In addition, the expansion of the gap between the rate of return of possible borrowers at all banks and the rate of return of possible borrowers at regional banks in FY2001-FY2002 period is mainly a reflection of the greater difference in profit rates by scale of business.
    Against this backdrop, in order to retain their fiscal soundness, regional banks need to enhance the functions of relationship banking, or in other words, a smooth provision of funds through cooperative risk management with regional corporations. Furthermore, the fiscal soundness of regional banks is closely linked with the economic structure of each region and with the issue of low profitability of small- and medium-sized corporations. In other words regional revitalization is a comprehensive theme, which includes the issues pertaining to local small- and medium-sized corporations, and it is necessary to implement on an even broader basis initiatives that will improve the profitability of regional economies by promoting efforts to address not only the issues faced by regional banks, but also the structural changes.
   
Evaluation of the soundness of the financial system
    It is clear from the above that stable improvement has been achieved with regard to the non-performing loans issue. However, it is also clear that the relation between the further enhancement of the profitability of regional banks and the initiatives for regional revitalization is much deeper. Here, an attempt is made to evaluate the extent of improvement in the soundness of Japan's financial system, with a wider removal of the full deposit guarantee in April 2005 approaching(34).
    In evaluating the financial state of Japanese banks, it is assumed that the elements for meeting the standards of bank management soundness are concentrated in the financial indexes of world's major banks and typical characteristics from these financial indexes are extracted. However, the soundness of the financial system greatly depends on the status of distribution of the soundness of major banks, which occupy a central position in the financial system, and is not directly related to the problems faced by each bank. Therefore, with regard to the soundness of the financial system, the average financial soundness of the major banks is appraised(35) (Figure 1-5-15).
Figure 1-5-15 Comparison of Principal Component Analyses
    According to the analysis, the characteristics extracted for the world's major banks can be interpreted as "basic profitability" and "safety" in descending order in terms of persuasiveness. The US financial system is highly profitable, while the European financial system is highly safe.
    Against this backdrop, the task before Japan's financial system as of March 2002 was to improve its soundness in terms of both basic profitability and safety. Next, during the period that ended in March 2003, the major banks aimed to progressively improve their basic profitability in line with the improvement of safety, and then worked toward introduction of bank management that places greater priority on profitability.
    In the future, banks will be required, in order to further improve their financial soundness, to break away from the existing homogenous management approach and to advance diversification of bank management by aspiring toward distinctive management models. Reducing common bank risks will become possible to contain the risks that threaten the finances of the country as a whole.
Changing trends in businesses borrowing from banks
    An argument over the financial reform exists to the effect that the disposal of banks' non-performing loans not only has a negative impact on the economy, but even if advanced, it will not result in increased lending because the demand for funds of enterprises is declining. Here, using financial data from separate enterprises and analyzing trends in bank borrowings from FY1999 onwards for listed companies (on a consolidated basis)(36), the factors that have an impact on the enterprises' borrowing from banks are examined (Appended Note 1-6).
    Corporate profitability (ratio of ordinary profit on sales) and safety (capital adequacy ratio) are considered factors that influence the demand for funds of enterprises, because if profitability is high, enterprises will increase fund procurement and will make investments, and if safety is high, the reduction in fund procurement costs will stimulate higher demand for funds. Apart from being factors that impact demand for funds on the side of enterprises, profitability ratio and safety are standards for lending estimation on the side of banks.
    It is believed that in addition to these factors, fluctuations in sales volume and in outstanding corporate bonds have an impact on companies' demand for bank borrowing. Growth of volume of sales results in an increase in financial transactions through expansion of transactions and projects. Corporate bonds are an alternative to bank borrowings.
    FY1999 was heavily impacted by the financial crisis, but since FY2000 the share of listed companies that have reduced (repaid) their bank borrowings has remained unchanged at approximately 65%; in other words, the situation has come to a standstill. Yet, even against this backdrop, the following changes can be observed in borrowings by listed companies (Figure 1-5-16).
Figure 1-5-16 Changing Trends in Businesses Borrowing From Banks
    First, high profitability (ratio of ordinary profit on sales) acted as a factor that stimulates repayment of bank borrowings. However, the impact of high profitability on the borrowing behavior of companies is gradually decreasing, and highly-profitable companies are beginning to use the gained cash flow for purposes other than repayment of bank borrowings.
    Second, companies that enjoy high safety (capital adequacy ratio) are demonstrating a more positive approach toward bank borrowings. This trend slightly dropped in FY2001, the year immediately after the collapse of the IT bubble, but gathered speed again in FY2002.
    Third, the increase in volume of sales became a factor that stimulated bank borrowings in FY2002.
    Fourth, bank borrowings that are considered as a way to refinance funds for redemption of bond issues increased in FY2002, but there is no evidence that the increased issuance of bonds from FY2000 onwards has a substitution effect on repaying bank borrowings in FY2002.
    From the above analysis it can be concluded that the enhanced cash flow of listed companies due to increased profitability used to be the main factor in repayment of bank borrowings, but in recent years the effect of bank borrowings is increasing based on improved safety, greater volume of sales and refinancing of funds for redemption of bond issues.
    Also, looking at the past trends of bank borrowings by group of listed companies that increased their borrowings in FY2002, it is obvious that they are moving from repayment of loans to increased demand for bank borrowings, and the gap between the growth of their sales volume and that of the group of companies that are repaying their bank borrowings is expanding (Figure 1-5-17). Therefore, there is no change in the ratio of listed companies that are repaying their bank borrowings, while the companies that are increasing their borrowings from banks are adopting an ever more positive stance, and their presence reflects the increased effect of bank borrowings.
Figure 1-5-17 Traits of Firms Increasing Their Bank Borrowing and Those Repaying Loans
    Furthermore, looking at the status of procurement and repayment of interest-bearing debt (sum of bank borrowings and bond issues), the repayment amount of companies that cut their debt in FY2002 remained almost flat until FY2001 and then nearly doubled in FY2002. Such a trend indicates that as listed companies are headed toward bi-polarization, companies with relatively low business performance have significantly reduced their debt in FY2002.
   
Reform of public financing/corporate sectors
    After examining the progress of reforms in the private sector described above, an outline the reforms in the public sector follows.
    During the lost decade of the 1990s, Japan entered an economic slump and the government had to take on a huge budget deficit. Also, as financial transactions in the private sector dwindled, public finance strongly made its presence felt (Figure 1-5-10).
    Against this backdrop, the government needs to review its role by leaving to the private sector what can be done by the private sector with the objective of fostering a dynamic private economy responsive to the needs created by a declining birthrates, aging society, and advancement of globalization. Also, Japan needs to further advance reforms toward more effective utilization of the financial sources allocation function of the market mechanisms.
    Public finance and projects are important mechanisms which supply funds to and develop activities in fields which are of great importance to the public interest but harbor risks that cannot be taken on by the private sector. On the other hand, in fields in which the public sector competes with the private sector, the fact that the public sector raises funds and carries out project management premised on government guarantees, is a clear obstruction of economic activity by the private sector. Therefore, in the event that the government interferes in areas, in which it is highly probable that the public sector will compete with the private sector, it will become necessary to strengthen the efficiency of systemized management through application of market discipline by procuring funds from the market and by improving information disclosure.
    This concept toward revitalization of the private sector economy and creation of a simple and effective government has become a fundamental approach in the reform of the public sector. Concretely, the government is implementing fiscal investment and loan reform, and, as closely-linked efforts, reform of special public institutions and initiatives toward privatization of the postal services.
    As part of the fiscal investment and loan reform, postal savings and pension funds were released from the obligation to make deposits in FY2001 and afterwards adopted the basic independent operation approach(37), in which funds that are truly necessary for conducting policies are procured from the market through the issuance of investment-and-loan bonds. Special public institutions and others are raising funds from the market through issuance of investment-and-loan institution bonds(38).
    As for the reform of special public institutions, apart from the abolition and privatization of some special public institutions in October 2002, the government is determined to implement thorough review of projects with regard to the newly-established "incorporated administrative agencies," and is working toward preparing all necessary legislative measures and others within the intensive adjustment period until FY2005. As for the current eight policy-based finance public institutions(39), the government plans to consider measures for the realization of appropriate modalities for these institutions from FY2008 onward, including strict selection of areas of activity, reduction of scale and review of organization, while taking into consideration the status of restoration and enhancement of financial functions in the private sector(40).
    As for the reform of postal services, which are closely related to the above-mentioned areas as a gateway to fiscal investment and loans, the Council on Economic and Fiscal Policy (CEFP) plans to compile the basic policies for their privatization by around the fall of 2004 and to submit a draft privatization bill in 2005.
    The advancement of the series of reforms described above is expected to trigger further strengthening of the foundations of the market economy and the setting in of the pattern of sustainable economic growth led by private-sector demand.
   
Evaluating the status of progress of financial reform
    In this section, the curtailment in financial transactions since the second half of the 1990s and the problem of domestic funds flow were examined, and the results applied to first confirm the status of progress of the disposal of non-performing loans at major banks and regional banks, and then to evaluate the improvement in the soundness of the financial system.
    It became clear that stable improvement is under way on the non-performing loans issue. However, the improvement in profitability of regional banks is closely linked to the structural problems faced by regional economies, and therefore requires implementation of comprehensive initiatives through regional revitalization. Major banks hold a core position in the overall financial system, and therefore contribute to the improvement in the safety and basic profitability of the system. Yet, the advancement in the diversification of major banks' management formats is expected to upgrade the risk resistance of the financial system in the future.
    The continuing slump in bank lending is related to the corporate demand for bank borrowings. The analysis of trends in listed companies borrowing from banks showed that in recent years there has been no change in the ratio of companies that are repaying their bank debt, but an increasing number of companies are moving from repayment of borrowings to increased borrowing. This is an indication that companies with increased demand for bank borrowings are further enhancing their positive attitude.
    Such reforms in the private sector are being developed in parallel with initiatives toward revitalization of the private economy and creation of a simple and efficient government in the public finance and corporate sectors as well. These initiatives recognize the importance of the public sector, and aim to advance reforms toward effective utilization of the financial sources allocation function of the market mechanisms as much as possible. Concretely, they incorporate fiscal investment and loan reform, reform of special public institutions and privatization of the postal services.
    From the above it can be concluded that while certain progress has been made in the implementation of financial reforms, it is necessary to gain sufficient understanding on the following two points: the necessity of further reform efforts, and the close relationship between financial reforms and structural reforms in other areas. Based on this acknowledgement, it is important to strive for further improvement of the financial intermediary function that underpins economic activity, and for firm establishment of a pattern of sustainable private-sector demand led economic growth.


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