Section 3 Developments of Fiscal and Monetary Policy

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1. Macroeconomic Impact of Fiscal Policy

blackcircle Concept of the fiscal structural reform

Japanese public finance is confronted with a considerably severe situation with the national and regional long-term debts amounting to approximately 700 trillion yen at the end of FY 2002, which is about 140% of the nominal GDP, and recording enormous deficits 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") every year.

Therefore, with regard to medium-term fiscal management, the government has set medium-term fiscal goals in the "Reform and Perspectives - FY 2002 Revision," which was adopted by the Cabinet in January 2003. These goals include: keeping the size of government (the ratio of general government expenditure to GDP) from exceeding its size in FY 2002; and achieving a primary surplus by the beginning of the 2010s through achieving economic growth led by private demand and efforts to improve the fiscal balance.

blackcircle Changes in the national budget

Taking a look at the results of the expenditure reform based on the national general account budget (original budget), the general expenditures allotted to policy costs have been restrained from 48.7 trillion yen in FY 2001 and 47.5 trillion yen in FY 2002 (a 2.3% decline from the previous fiscal year) to 47.6 trillion yen in FY 2003 (a 0.1% increase from the previous fiscal year). Meanwhile, the aggregate amount of general account expenditures, including expenditures on servicing outstanding government bonds and local allocation tax has shifted from 82.7 trillion yen in FY 2001 and 81.2 trillion yen in FY 2002 (a 1.7% decline from the previous fiscal year) to 81.8 trillion yen in fiscal 2003 (a 0.7% increase over the previous fiscal year).(43)

Despite such effort to cut spending, however, the amount of government bond issuance has continued to increase due to the constant decline in tax revenue. The amount of government bond issuance increased from 28.3 trillion yen in FY 2001 to 36.4 trillion yen in FY 2003 with the dependence on government bonds reaching 44.6%.

blackcircle National budget: general account and special accounts

What impact does such expenditure reform have on the breakdown of expenditures? We will look at the general account budget and special accounts budget for FY 2002 and FY 2003 below.

Taking a look at the ratio of the amount of the special accounts budget to that of the general account budget (the special accounts budget divided by the general account budget) to compare their sizes, the ratio had been about two to three to one from the 1970s to the latter half of the 1980s, but it increased throughout the 1990s and reached 4.5 to one (special accounts budget: 369 trillion yen; general account budget: 82 trillion yen) in FY 2003 (see Figure 1-3-1). While this increase is attributable to the growth in size of the special accounts budget, notably large items are the special account for national consolidation fund (158 trillion yen) and special account for local allocation tax and that for gift tax allocation (67 trillion yen). The net budget amount combining the general account and special accounts (adjusting the overlapping portions of the accounts) has been on a decline after peaking in FY 2001.

Figure 1-3-1 Ratio of Special Accounts to General Account

blackcircle General account of the national government

Next we will look at the changes in the budget of the detailed items of the general account and special accounts. In this process, we will use "classification by economic characteristics."(44) Here, expenditures will be largely divided into four categories: 1) capital formation; 2) current expenditure; 3) transfer expenditure; and 4) other (see Figure 1-3-2).

"Capital formation" mainly consists of public investment. "Current expenditure" includes compensation of employees (wages of public officials). "Transfer expenditure" includes current subsidies from the national government to local governments and social assistance benefits (welfare allowances, etc.). Here, they include not only national projects, but also funds transferred to local governments. "Other" includes overlapping portions between accounts, among other items. We will now look at each one of these.

Figure 1-3-2 Expenditure by Economic Characteristics

1) "Capital formation" has been on a decline in recent years. Specifically, subsidies to local governments (e.g., sewage works, rural community sewage works, and establishment/improvement of waste disposal facilities).(45)

2) "Current expenditure" increased slightly in FY 2002, but declined in FY 2003. The accountable factors include a nearly 10% decline (-25.57 million yen) in the national government's share of compulsory education expense resulting from reviewing the role-sharing between the national and local governments regarding compulsory education, and limiting the national government's share of expenditure in order to dramatically expand the freedom of local governments.

3) "Transfer expenditure" increased in FY 2003 mainly due to an increase in "current subsidies." Furthermore, "social assistance benefits" slightly increased in FY 2003 because of such factors as an increase in the welfare allowance expenditure (+ 138 billion yen).

4) "Other" mainly consists of "overlapping portions between accounts," most of which accounts for funds transferred to special accounts (about 85% of all overlapping portions between accounts, and nearly 70% of the overall general account. See "Special accounts of the national government" below with regard to the background to the changes). The considerable decline in parts other than the "overlapping portions between accounts" in FY 2002 is due to such factors as the raise in the amount of investment pertaining to consolidation and streamlining of government organizations or their transformation into independent administrative corporations.(46)

blackcircle Special accounts of the national government

Next, we will look at special accounts. Special accounts expenditures rose in FY 2002, but declined in FY 2003. The reasons behind it are as follows (see earlier Figure 1-3-2).

1) "Capital formation" has been restrained. The expenditures of the flood control special account (e.g., dam construction, erosion control, and river improvement) and the port improvement special account (e.g., port and harbor improvement) declined for two consecutive years.(47) While the expenditures of most of the other special accounts also remained flat or declined, the expenditures of the road improvement special account rose in FY 2003. This is attributable to an increase in the national expressway construction expenses(48) and transport linkage promotion project expenses, among others (see Figure 1-3-3).

Figure 1-3-3 Changes in Capital Formation of Special Accounts

2) "Current expenditure" is gradually declining. The government's share of burden decreased due to the lowering of medical treatment fees (April) and the raise in patients' self-pay burden for medical care for the elderly (October) in FY 2002, and the raise in the self-burden of medical costs in FY 2003. As a result, insurance benefits declined (FY 2002: -205.5 billion yen; FY 2003: -250.4 billion yen) in the welfare insurance special account.

3) Among the items under "transfer expenditure," "current subsidies" have shifted more or less at the same level, while "social security benefits in cash" has been on the increase. This is because the expenditures of the welfare insurance special account and the national pension special account increased for two consecutive years pertaining to aging of population. In the welfare insurance special account, insurance benefit expenses (FY 2002: + 691.4 billion yen; FY 2003: +303.2 billion yen) contributed to the increase, and in the national pension special account, basic pension benefit expenses (FY 2002: +1.0 trillion yen; FY 2003: +852 billion yen) contributed.

4) "Other" increased in FY 2002, but dropped considerably in FY 2003. The special account for the national debt consolidation fund (debt redemption costs pertaining to increased issuance of government bonds) has consistently served as an expansion factor. On the other hand, the downward factors have been the fiscal loan fund special account (phased reduction of fiscal loan funds [i.e., fiscal resources for loans] pertaining to the fiscal investment and loan reform <FY 2002: -9.5 trillion yen; FY 2003: -4.3 trillion yen>) and the road improvement special account (e.g., non-inclusion of investment to the Japan Highway Public Corporation according to the Reorganization and Rationalization Plan for Special Public Corporations <FY 2002: - 304.8 billion yen>; non-inclusion of loans in line with detachment of part (1.3 trillion yen) of interest-bearing debts of the Honshu-Shikoku Bridge Authority as an interim measure for the privatization <FY 2003: -180 billion yen>). Furthermore, in FY 2003, abolition of the special accounts of the three postal services, pertaining to the establishment of the Japan Post (April 2003), also contributed to the expenditure increase (37.6 trillion yen).

The above analysis suggests the following trend.

First, expenditures are restrained both in the general account and the special accounts. It includes the impact of the administrative reform (consolidation and streamlining of government organizations or their transformation into independent administrative institutions under the Reorganization and Rationalization Plan for Special Public Corporations, and establishment of Japan Post).

Second, a fall in capital formation has contributed greatly to the decline in expenditures. While the expenditures are decreasing for most operations, those of the road improvement special account has been increasing due to a rise in the national expressway construction expenses under the new direct control method introduced as a complementary measure for the improvement operations undertaken by the new company after the privatization of the four public highway corporations, and an increase in transport linkage promotion projects.

Third, among the government expenditures, the decline in current expenditure has been caused by the medical care system reform among other factors.

Fourth, among the government expenditures, transfer expenditure is increasing. This is largely due to the social security-related spending serving as an expansion factor.

Fifth, in the "Other" category, the increase in debt redemption expenses under the special account for national debt consolidation fund is having a large impact.

The state of public finance remains severe. Therefore, efforts must be continued to achieve a sustainable public finance. The "Basic Policies for Economic and Fiscal Policy Management and Structural Reform 2003," adopted by the Cabinet in June of this year, indicated that the FY 2004 budget should be allocated with distinct priorities under a basic concept. This concept is to remain on course for expenditure reform, such as exercising maximum restraint in the issuance of government bonds, and ensure fiscal sustainability, to give priorities to policies that utilize maximum private sector potentiality, and to restrain government spending while taking into account price trends and the simplification and streamlining of administrative services. It is important to steadily promote the fiscal structural reform while giving consideration to the macroeconomic impacts.

blackcircle General government fiscal expenditures remaining flat

Let us examine the macroeconomic impacts of fiscal policy under such fiscal structural reform. National budget-based figures as above are not sufficient to make this analysis. Original budget-based figures do not include the loss and profit brought forward or the supplementary budget. Nor does it take into account the impact of the social security funds. Moreover, the spending of local governments must also be taken into consideration. Given these points, we will examine the macroeconomic impacts of fiscal policy on a general government basis (combination of the national government, local governments, and social security funds).

Taking a look at the general government-based fiscal expenditure trend (see Figure 1-3-4), the aggregate amount of fiscal expenditures had been on the rise throughout the 1990s, and became flat from FY 1999 to 2001. With regard to the changes in public investment and government final consumption, which are fiscal expenditures that are themselves part of final demand, government final consumption has been increasing due to the increase in medical care benefits and nursing care benefits pertaining to the aging of population. On the other hand, public investment has been decreasing since FY 1999. The proportion of Japan's public investment in the GDP is high, and as a result of the repeated expansion of fiscal spending to boost the economy in the 1990s, the proportion had got stuck at high levels. The government has been reducing public works projects under the fiscal structural reform, and cut the public works-related expenses by 3.9% from the previous fiscal year in the FY 2003 original budget.

Due to these circumstances, public demand, which combines public investment and government final consumption, has more or less leveled out.(49) As a result, the contribution of public demand to the GDP growth rate was a 0.0 percent point in FY 2001 and a minus 0.1 percent point in FY 2002, continuing to be almost zero. The contribution is expected to become 0.0 percent point in FY 2003 according to the FY 2003 government economic forecast.

Figure 1-3-4 General Government Expenditures

blackcircle Fiscal revenues fell due to a decline in tax revenues

We will now look at the general government revenues (Figure 1-3-5).

Tax revenues declined in FY 2001 due to the declined contribution of special factors (tax revenue increase pertaining to concentrated maturing of postal savings)(50) and the decline in taxable income. Also in FY 2002, national tax revenues on a general account basis has dropped by about 4 trillion yen due to a fall in nominal GDP, and they are likely to have also decreased on a general government basis. The general account budget of the nation for FY 2003 assumes a tax revenue drop of about 5 trillion yen from the FY 2002 original budget, mainly in the areas of corporate tax and income tax, as a result of a fall in nominal GDP and tax reduction measures including concentrated and focused tax cuts in the areas of R&D and business investment.

The social security burden increased in FY 2001 by 2.0% (approx. 1 trillion yen) over the previous fiscal year due to an increase in premium payments pertaining to the full-fledged introduction of the nursing care insurance and the raising of employment insurance premiums. The social security burden is also likely to have increased in FY 2002 by about 1.0% (approx. 0.5 trillion yen). The burden is again expected to increase by about 1.5% (approx. 0.8 trillion yen) because of the introduction of a system to apply the same health insurance premiums to monthly salaries and bonuses.

Figure 1-3-5 General Government Revenues

The total revenues in FY 2001 remained on the same level because despite a decrease in tax revenues, the social security burden increased. In FY 2002, the total revenues were flat or declined slightly due to a fall in tax revenues, although the social security burden increased. A similar movement is expected also in FY 2003.

blackcircle Expanding fiscal deficit

As a result of the above, general government fiscal deficit remained on the same level from 34 trillion yen (6.6% of nominal GDP) in FY 2000 to 33 trillion yen (6.6% of nominal GDP) in FY 2001. This was because, while the increased social security benefits and the increased government consumption contributed as factors that expanded the fiscal deficit, the decreased public investment and increased social security burden served as deficit-reducing factors. According to estimation, the deficit is expected to slightly increase in FY 2002 (see Figure 1-3-6).

Fluctuations of fiscal deficit can be divided into cyclical balance (fiscal balance that fluctuates with the economic cycle) and structural balance (fiscal balance excluding the cyclical balance) (see Figure 1-3-7).

In FY 2001, structural deficit, which had continued to be at a high level, decreased slightly compared to its size in FY 2000, but cyclical deficit expanded due to a fall in tax revenues. In FY 2002, structural deficit increased slightly, while cyclical deficit remained flat.

Figure 1-3-6 Factor Analysis of General Government Deficit (Year-on-Year Changes)

Figure 1-3-7 Cyclical Budget Balance and Structural Budget Balance of General Government

blackcircle Macroeconomic impacts of fiscal policy

As discussed above, while fiscal expenditure remains on the same level, fiscal deficit is slightly expanding due to weakened revenues. Therefore, the direct macroeconomic impacts of general government-based fiscal policy are not considered to be negative even under the spending reform.

It should also be noted that fiscal reconstruction could have a positive effect (non-Keynesian effect)(51) on private consumption, etc., depending on the situation of the economy and public finance.

2. Effects of Quantitative Easing

The Bank of Japan has gradually raised the target balance for current accounts at the BOJ since it adopted the quantitative easing policy in March 2001. As a result, monetary base is showing high growth, but this has not lead to high growth in money supply. In this part of the report, we will first go over the details of the quantitative easing policy, then overview the trends of quantitative monetary indicators, and analyze the effects of the quantitative easing policy.

blackcircle Quantitative easing policy

The BOJ adopted a "quantitative easing policy" at the Monetary Policy Meeting on March 19, 2001 (see Figure 1-3-8). The content particular to the quantitative easing policy can be roughly divided into the following two parts.

Figure 1-3-8 Recent Trend of Monetary Policy

First is changing the major instrumental target in money market adjustment from the conventional unsecured call rate (overnight call money) to the balance of current accounts at the BOJ deposited by banks.

Second is to increase the amount of purchase of long-term national bonds to an amount not exceeding the balance of bank notes issued when it is considered necessary for smoothly supplying the current deposits at the BOJ.

This was aimed at achieving a further monetary easing effect under a situation where the short-term market interest rate had become close to zero as a consequence of repeated monetary easing policies. Furthermore, BOJ decided to continue such new procedures for money market operations until the year-on-year change of the consumer price index (excluding perishables, on a nationwide basis) registers stably a zero percent or an increase year on year. Such a step of clarifying the duration of the new procedures and the commitment to future monetary easing was expected to contribute to lowering the long-term interest rate, as well as to rectifying people's deflationary expectations. This effect is called the "policy duration effect."

At the beginning, the target current account balance at the BOJ was set at around 5 trillion yen, but it has been gradually raised since then to the level of about 27 to 30 trillion yen as of August 2003. The purchase amount of long-term national bonds has also been increased from the initial pace of 400 billon yen per month to 1.2 trillion yen per month as of August 2003.(52)

blackcircle Monetary base achieving high growth

The monetary base (current deposits at the BOJ plus currency in circulation) dramatically increased since the adoption of the quantitative easing policy (see Figure 1-3-9). While the year-on-year increase in February 2001, immediately before the adoption of the quantitative easing policy, was 3.4%, it reached 36.3% by April 2002. (53) Although its growth slowed down after that, it still indicates high growth of 20.5% as of August 2003.

blackcircle Money supply posting low growth

When monetary base increases, money supply is usually expected to grow as well. However, even after the adoption of the quantitative easing policy, money supply growth has remained low.

Money supply (M2+CD), which had been growing by 2.5% in March 2001, posted slightly higher growth until the July-September quarter of 2002 (see earlier Figure 1-3-9). However, from the October-December quarter of 2002, the growth slowed down, and declined to 1.8% by July 2003.

When we look at the money supply fluctuation factors based on the flow-of-funds statistics, lack of funds of the overseas sector (current account surplus) and lack of funds of public finance (fiscal deficit) are serving as positive factors. On the other hand, negative factors are a decline in borrowings from private financial institutions and the surplus of available funds in the financial sector. The total of these factors has produced positive growth, but the growth has been slowing down since 2002 (see Figure 1-3-10).

The money supply fluctuation since 2001 has been greatly affected by fund shifts with "other deposits and savings (deposits and savings at financial institutions that are not included in money supply, such as postal savings)" or "assets other than cash equivalents (securities, etc.)" With regard to "other deposits and savings," capital inflow arising from a large number of mature postal savings was observed since the first quarter of 2001, but such a dramatic inflow ended by the fourth quarter of 2002. As to "assets other than cash equivalents," cancellation of investment trusts increased from the fourth quarter of 2001 until the first half of 2002 in connection with the failure of Enron, which brought an inflow of capital, but this impact settled down by the fourth quarter of 2002. With such impacts of fund shifts set aside, the money supply growth rate has been flat or declined since 2000.

Figure 1-3-9 Monetary Base and Money Supply

    The fact that no dramatic change has been observed in money supply growth despite the accelerating growth of monetary base means a decline in monetary multiplier (money supply divided by monetary base). Indeed, the monetary multiplier has been inclined to fall since the beginning of 2001 (see earlier Figure 1-3-9).

Figure 1-3-10 Money Supply Fluctuation Factors from Currency Holders' Perspective

When we look at the factors that are causing a decline in the monetary multiplier, we can see that growth in "the ratio of balance of current accounts at the BOJ to bank deposits", and "the ratio of cash to bank deposits," contribute to the decline (see Figure 1-3-11). Among these factors, growth in "the ratio of balance of current accounts at the BOJ to bank deposits" indicates that the short-term rises of the target current account balance at the Bank of Japan have not resulted in corresponding growth in bank deposits. On the other hand, the latter indicates that cash is being preferred to bank deposits due to such reasons as the low interest rates and partial removal of the full deposit guarantee. If these signs become stronger, more would be left out of the credit creating process, and money supply growth would be restrained correspondingly.

Figure 1-3-11 Factors of Monetary Multiplier Fluctuation

blackcircle Monetary velocity also declining

Even if growth rate of money supply is low, monetary policy can be considered to have some-albeit limited-effects as long as it is spurring economic activity. We will now take a look at monetary velocity (nominal GDP divided by money supply) in order to examine this point (see Figure 1-3-12). According to this, monetary velocity has been flat since the beginning of the 1990s, but has been on a decline since 1998. This trend has not changed even after March 2001 when the quantitative easing policy was adopted.

The decline in monetary velocity is considered to be attributable to: 1) an increase in money demand that is not directly associated with economic activities due to concerns over the soundness of the financial system and the Y2K problem; and 2) a decline in the lending for business investment, which is itself part of final demand and has large spillover effects on all economic activities.

Figure 1-3-12 Velocity of Money

blackcircle Expected effects of the quantitative easing policy

Do the declines in the monetary multiplier and monetary velocity mean that the quantitative easing policy is ineffective? We will now examine this point starting by confirming the channels of the expected effects of quantitative easing policy.

An expected effect that is distinctive to the quantitative easing policy is the portfolio rebalancing effect. This is to expect that, when deposits in current accounts at the Bank of Japan, which are safe for financial institutions but do not yield interest, accumulate through the BOJ's supply of abundant liquidity to the markets, financial institutions restructure their portfolios (asset combinations) in pursuit of advantageous higher-risk, higher-return investment. If loans increase as a result, business investment will be promoted, and if purchase of foreign government bonds is stimulated, export will be promoted through depreciation of the yen. In the following part of the report, we will evaluate the effects of the quantitative easing policy by paying attention to this portfolio rebalancing effect.

blackcircle Effects of quantitative easing policy to date

With regard to bank portfolios (composition of assets), the total assets of domestic banks declined by approximately 20 trillion yen from March 2001 to March 2003 (see Figure 1-3-13). When we break this down, we can see that high-risk corporate loans declined from 51.3% to 47.9% and stock also decreased from 5.0% to 2.5%. In contrast, personal loans (mainly housing loans) increased from 10.4% to 11.7%, while investment in foreign securities also rose from 1.8% to 2.1%. At the same time, however, government bonds rose from 11.5% to 13.4% and cash/deposit balance also increased from 3.8% to 5.1%.(54) Therefore, we cannot necessarily say that risk assets have gained weight in banks since the adoption of the quantitative easing policy.

Figure 1-3-13 Changes in Portfolios of Japanese Banks

As to the trend of investment in foreign securities, Japanese investors have been net buyers of foreign securities (see Figure 1-3-14). By type of investors, the most contributing investor is the general government, which is likely to hold foreign government bonds acquired by investing foreign exchange reserves that have been raised through yen selling and dollar buying operations. Banks also further increased foreign securities investments from the April-June quarter of 2002. The intention is likely to have been to gain interest receipts through operations at relatively high overseas interest rates. However, foreign securities investment by banks is considered to be mostly hedged.

Studying the impact of monetary base on exchange rate under such a situation, monetary base growth is found to have had an effect of causing a depreciation of the yen since the 1990s (see Appended Note 1-7 for details). However, robust effects have not been achieved since the adoption of the zero interest rate policy in 1999 and the quantitative easing policy in 2001.(55) This could have been affected by the influence on the foreign exchange market of the financial system uneasiness in 1998, the terrorist attacks in the United States in September 2001, and the Iraq War in 2003.

Figure 1-3-14 Foreign Securities Investment

blackcircle Reasons for absence of visible effects of the quantitative easing policy

Why have the expected effects of the quantitative easing policy not been sufficiently shown? The conceivable reasons are as follows.

First, financial institutions, which have enormous amounts of NPLs and whose risk tolerance has dropped, are cautious about bearing new risks. In addition, as credit risks have risen mainly for companies holding excessive debts and financial institutions could not set risk-matching interest rates until recently, financial institutions had no incentive to increase loans. Alternatively, financial institutions purchased a large amount of low-risk government bonds. The decrease in loans is also considered to have lowered monetary velocity.

Second, the period after the adoption of the quantitative easing policy was a time when banks' liquidity demand was high, and this has offset the effects of the quantitative easing policy. For example, we saw the failure of large companies in January 2001, the occurrence of the September 11, 2001 terrorist attacks in the United States, failure of the systems of some large banks and the lifting of the special measure to protect the entire deposit amount (partial removal of the full deposit guarantee) for fixed time deposits etc. other than liquidity deposits in April 2002. Thus, it was a time when banks' preference for liquidity became stronger. This is likely to have contributed to lowering the monetary multiplier.

blackcircle Future measures

In the present situation where the portfolio rebalancing effect, the effect specific to quantitative easing policy, has not been achieved as was originally expected, what direction should future monetary policy take?

The portfolio rebalancing effect by the quantitative easing policy was primarily to influence banks' portfolios by making the current account balance at the BOJ the instrumental target. However, due to the NPL problem in the banking sector, it has been unable to sufficiently promote an increase in loans or purchase of risk assets by banks.

Accordingly, the government needs to establish an environment in which private demand is created in a sustainable manner through structural reform by promoting NPL disposal and normalizing indirect finance as early as possible. The BOJ is also expected to implement effective monetary policy operation. While we will discuss about the government's efforts to address the NPL problem in Chapter 2, the BOJ has also taken a measure to reinforce the monetary easing transmission mechanism by activating corporate finance through the asset-backed securities market at the end of July 2003.(56) Such measures should continue to be promoted.

In recent years, banks have tended to purchase low-risk government bonds instead of increasing loans due to their lower risk tolerance. Thus, the ripple effects of quantitative easing on private non-financial institutions may have remained limited (see earlier Figure 1-3-13). Therefore, in order to make the quantitative easing policy more effective, the BOJ should continue its efforts to enhance the effectiveness of its present policy, as well as to study and implement a more effective monetary policy by giving consideration to what financial assets and from whom the BOJ should purchase and what approaches should be taken to people's expectations.

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