Statement by the IMF Staff Representative August 3, 2001

The new government in Tokyo has a window of opportunity to address the deep-seated structural problems that lie at the root of Japan's lackluster economic performance over the past decade. The government has appropriately identified banking sector problems as a top priority. Broader reforms are needed to strengthen the regulatory framework and lay the basis for a sound banking system. In the near term, fiscal policy should remain responsive to changing economic circumstances. Enhancing the transparency of the monetary policy framework is required.

Abstract

The new government in Tokyo has a window of opportunity to address the deep-seated structural problems that lie at the root of Japan's lackluster economic performance over the past decade. The government has appropriately identified banking sector problems as a top priority. Broader reforms are needed to strengthen the regulatory framework and lay the basis for a sound banking system. In the near term, fiscal policy should remain responsive to changing economic circumstances. Enhancing the transparency of the monetary policy framework is required.

Statement by the IMF Staff Representative August 3, 2001

1. This statement provides an update of information that has become available since the release of the staff report (SM/01/221, 7/13/01). It reflects further discussions held in Tokyo during July 25–26 with senior government officials and private sector analysts. The statement covers the political situation, recent monthly data, policy developments, and financial market developments. This information does not alter the thrust of the staff appraisal.

2. The ruling LDP-led coalition secured a solid victory in the July 29 Upper House elections, strengthening Prime Minister Koizumi’s mandate to pursue structural reforms. Of the 121 seats up for election, the LDP won 65 and its coalition partners an additional 14. The coalition increased its majority in the Upper House by two, and now holds 140 of the 247 seats. The Prime Minister said that details of his structural reform program would become available in three stages during the remainder of the year.

3. Recent data suggest that economic activity likely contracted in the second quarter, following the 0.2 percent (quarterly rate) decline in the first quarter.

  • Industrial production declined by 0.7 percent (m/m) in June and by 4 percent (quarterly rate) in the second quarter. The weakness in the industrial sector also now appears to be spreading. The all-industries production index (the closest supply-side proxy of GDP) declined in both April and May, after registering modest growth in the first quarter. In response to declining demand, firms have reduced employment levels, and the unemployment rate edged up to 4.9 percent in June.

  • Retail sales and spending by worker households in real terms fell sharply in the second quarter as purchases of household appliances dipped after the introduction of a new recycling law on April 1. Shipments of capital goods have weakened, consistent with indications in the June Tankan survey that firms intend to reduce capital expenditures this financial year. Based on public works contracts and construction data, it is likely that public investment declined in the second quarter, while residential investment has fallen further.

  • Weakness in overseas markets, particularly for high-tech products, has continued to undermine exports, with volumes declining by 6 percent (quarterly rate, customs clearance basis) in the second quarter. Import volumes fell by 2½ percent.

  • Year-on-year declines in the CPI continued at unchanged rates in June. The overall CPI declined by 0.5 percent, while the core CPI, which excludes perishable food and energy, declined by 0.6 percent.

On balance, these developments are consistent with the staffs forecast in the staff report that real GDP will decline by ¼ percent in 2001 as a whole. We expect real GDP to decline in the second and third quarters, but to rebound modestly in the fourth quarter.

4. Macroeconomic policies remain much as described in the staff report. The new monetary policy framework has worked more smoothly over the past two months than in the March-April period, partly reflecting some technical changes introduced to the auction process which have made under-subscriptions much less likely. Regarding fiscal policy, the Government has announced that it will finalize the guidelines for FY2002 budget proposals by August 10. Officials have again reiterated to the staff that a supplementary budget will only be considered after the release of the second quarter national accounts in September. If such a fiscal package were to be implemented, officials indicated that it would likely place less emphasis on public works spending, in favor of other steps (including expanding the social safety net).

5. With regard to the bad loan problem, Financial Services Minister Yanagisawa has recently indicated that nonperforming loans may be higher than indicated hi banks’ self-assessments. This assessment is based on the ongoing FSA inspection round for major banks, where NPLs (loans in the “needs special attention,” “near bankrupt” and “bankrupt” categories) were found to be about 25 percent higher than under the banks’ self assessments. The FSA has announced that it will carry out follow-up inspections at the major banks over the next two months to assess whether they have corrected the loan classification problems identified. The FSA also plans to begin conducting its regular inspections of the major banks on an annual basis, rather than once every 18–24 months as at present. During the recent staff visit, FSA officials reiterated their view that provisioning standards and practices in Japan were in line with those in other major countries. They believed that only loans to borrowers in the “need special attention” category or below should be classified as nonperforming, and were concerned that conservative provisioning without an objective basis could bring about an artificial reduction in bank profits before dividend payments and impinge on shareholder interests. The FSA considered that, for accounting purposes, banks should accumulate provisions based on objective data, such as historical loss rates, while for risk management purposes lending policies and loan conditions should be adjusted according to credit risk.

6. Further details have emerged about specific aspects of the April and June banking sector policy packages. To facilitate the use of debt-to-equity swaps in corporate restructuring agreements, operational guidelines have been revised to clarify when exemptions will be made to the 5 percent limit (stipulated in the Banking Law) on a bank’s equity holding in a company. Specifically, exemptions will be considered provided that banks dispose of their excess equity holdings promptly after the completion of the firm’s restructuring plan. The government has also provided an outline for the funding of the Banks’ Shareholding Acquisition Corporation (BASAC), which is to assist banks in unwinding their share portfolios. According to the proposal, member banks would be expected to provide a total of ¥10 billion in initial capital, plus additional subordinated contributions worth 8 percent of their share sales to the BASAC. The government would provide up to ¥2 trillion in guarantees for loans to fund share purchases (except in the case of shares being repackaged into mutual or exchange-traded funds or some shares being bought back by their issuer), although guarantees would only be invoked if member contributions proved insufficient to cover losses in the first instance. The proposal is still subject to further debate, however, and the limit for government guarantees may be reviewed in the context of discussions preceding the necessary budget appropriations.

7. The authorities have clarified the proposal to expand the role of the Resolution and Collection Corporation (RCC) in absorbing major banks’ remaining nonperforming loans in 2–3 years time. It is expected that the involvement of the RCC in the loan disposal process will permit the resolution of the most difficult cases that—owing to legal complexities or the involvement of crime syndicates—the banks do not have the expertise or legal leverage to handle themselves. To facilitate its expanded role, a new section will be created within the RCC to deal with corporate restructuring and to conduct judicial and voluntary workouts through the Civil Rehabilitation Law and the Guidelines on Voluntary Workouts, which will be finalized in September. The RCC will also expand its role in securitization of NPLs and real estate collateral, including by obtaining a trust bank license. Because of its track record on purchases (on average it has paid less than 5 percent of the face value of loans in recent years), officials and private analysts felt the risk that the RCC would purchase bad loans from banks at inflated prices was low.

8. The Council for Regulatory Reform has recently issued its interim report on deregulation. The report focuses mainly on the need for reform in social services where deregulation has been slow. The Council’s report recommends measures to encourage private sector involvement in the management of hospitals and other medical facilities, and further deregulation in the elderly and child care sectors to permit greater private sector service provision. It also proposes measures to revitalize the real estate market, as called for in the government’s April economic package, including the systematic disclosure of real estate transaction prices to increase transparency and liquidity in the market. The Council has proposed that the reforms it has identified be completed within three years.

9. Equity and bond markets have weakened in recent weeks. Concerns about the worsening economic outlook have undermined sentiment in the equity market. The Nikkei and Topix have both fallen by 8½ percent over the past month. The bond market has also weakened, with yields on 10-year government bonds rising by around 20 basis points to 1.35 percent. The yen has remained broadly unchanged against the U.S. dollar (at ¥124.8/$) and in nominal effective terms.

Japan: Staff Report for the 2001 Article IV Consultation
Author: International Monetary Fund