The Japanese economy is vulnerable to external and domestic shocks. The new government has made a commitment to turn the fiscal situation around. The new policy framework provides the Bank of Japan with the scope to ease the policy stance. A deteriorating macroeconomic environment has exposed underlying structural problems in the banking sector. Over the past year, Japan maintained its traditional emphasis on pursuing further trade liberalization through the World Trade Organization (WTO) framework, while at the same time initiating talks on bilateral free trade agreements.

Abstract

The Japanese economy is vulnerable to external and domestic shocks. The new government has made a commitment to turn the fiscal situation around. The new policy framework provides the Bank of Japan with the scope to ease the policy stance. A deteriorating macroeconomic environment has exposed underlying structural problems in the banking sector. Over the past year, Japan maintained its traditional emphasis on pursuing further trade liberalization through the World Trade Organization (WTO) framework, while at the same time initiating talks on bilateral free trade agreements.

III. Monetary Developments1

1. Faced with a weakening economy, the Bank of Japan (BOJ) in March 2001 returned to an ultra-low interest environment in the context of a new policy framework that targets the level of current account balances (bank and nonbank deposits) held at the BOJ. The new framework—which is to remain in place until year-on-year changes in consumer prices rise stably to zero or above—includes the possibility that the BOJ might engage in quantitative easing by raising the current account target and step up purchases of government bonds, if needed, to meet the target. Since implementing the new framework, interest rates have declined along the yield curve, but overall monetary conditions are not substantially different from levels in the first half of 2000, when the economy was considerably stronger. The BOJ has not used the flexibility under the new framework so far, partly because of concerns that a higher target might be difficult to achieve, and partly because of the uncertain nature of the monetary transmission mechanism at zero interest rates.

A. Policy Developments

2. Having abandoned its zero-interest rate policy (ZIRP) in August 2000, the Bank of Japan (BOJ) began to change its view of the economy later in the year. Through most of the second half of 2000, the BOJ’s assessed that a gradual economic recovery—driven by increasing corporate profits and strong business investment—was underway, which would eventually lead to a narrowing of the supply-demand gap and a subsequent pickup in inflation. This view—which underpinned the assessment that deflationary concerns had been dispelled and thus paved the way for the lifting of the ZIRP—was increasingly inconsistent with the deterioration in economic indicators, and persistent price declines which cast doubt about whether the output gap was narrowing.2 The BOJ revised its economic assessment in mid-December 2000 when it acknowledged that the pace of the recovery was slowing, owing to decelerating export growth. By that time, renewed concerns over the health of the banking system had also emerged, following the release of weak interim results for FY2000 and the precipitous decline in the stock market that eroded banks’ latent capital gains.

3. The BOJ’s first response to the worsening outlook was to address liquidity concerns in the financial system. According to the minutes for the January 19 meeting, several Policy Board members suggested that a preemptive interest rate cut to ward off further economic slowdown and ease financial sector concerns would be appropriate under normal circumstances. Under almost zero rates, however, Board members felt that the impact of a small reduction in the overnight rate would be negligible and thus decided to leave rates unchanged. Instead, BOJ staff were asked to explore ways by which sufficient liquidity could be provided to the markets, particularly towards the close of the financial year in March. This led to the introduction of a Lombard-type facility at the following Policy Board meeting.

4. Under the new “Complementary Lending Facility”, announced on February 9, the BOJ stands ready to provide potentially large funds to financial institutions on demand (against collateral), as opposed to the injection of liquidity on auction dates chosen by the BOJ.3 Borrowers are charged the BOJ’s “basic loan rate” (or discount rate), which was reduced by 15 basis points to 0.35 percent on the same date. While the move eased concerns about the availability of overnight liquidity, the impact on monetary conditions was likely small. At that time, the discount facility was no longer in use, and loans under the new facility are only available for a total of 5 working days out of every reserve maintenance period (currently one month).4 Loans taken out in excess of 5 days are charged an additional premium of 200 basis points.

5. In a second step, the BOJ decided to lower the target for the overnight call rate by 10 basis points to 0.15 percent on February 28. This decision was mostly triggered by economic considerations, particularly the news that industrial production had deteriorated in January.

6. Finally, the BOJ announced a shift to a quantitative operating target for monetary policy on March 19, a move that caused short-term interest rates to fall again to their floor. The policy has three main components:

  • While overnight rates are to be market-determined in the future, the BOJ now targets current account balances held by its counterparts at around ¥5 trillion—about the same as during the ZIRP period and some ¥1 trillion above the average balance held in the months prior to the introduction of the new policy (see below). As a result, the overnight call rate—now determined on the basis of supply and demand—has remained close to zero for most of the period since the policy has been in place.

  • The policy is to remain in place until annual CPI inflation (excluding perishables) has reached zero or above on a sustained basis. This distinguishes the new policy framework from the earlier zero-interest rate policy, which only sought to maintain zero interest rates until deflationary concerns were dispelled—a much vaguer notion.

  • The BOJ is also prepared to step up outright purchases of long-term government bonds (rinban operations) if necessary to meet its liquidity target, which is a significant departure from its earlier policy of purchasing a fixed amount of government bonds in secondary markets each month. The amount of JGBs owned by the BOJ is not to exceed the sum of outstanding banknotes, which is estimated to allow the BOJ to purchase an additional ¥10–15 trillion in JGBs if needed.

7. The new policy framework, while similar to the original ZIRP, is stronger because of its explicit commitment to maintain the current stance until deflation has been eliminated, and because of the built-in flexibility to raise the current account target if necessary. However, the new policy does not constitute a shift towards the adoption of an inflation target, mainly because the BOJ has not committed itself to eradicate deflation within a particular timeframe. In its October 2000 report on price stability, the BOJ expressed concern that monetary policy instruments may no longer be effective in a deflationary phase characterized by zero nominal interest rates and balance sheet adjustments. In such circumstances, the BOJ could have only limited impact on the price level. Indeed, growth and inflation forecasts by members of the BOJ’s Policy Board—which have been published on a semi-annual basis since October 2000—indicate that the Board on average expects a continuation of the deflationary environment in FY2001. Moreover, as revealed in the minutes of recent Board meetings, some Board members have been concerned about the difficultly of achieving a higher policy target, as financial institutions’ demand for additional funds might be insufficient. Consistent with these views, the Board has so far refrained from making use of the additional flexibility provided under the new policy framework.

B. Interest Rates and Monetary Stance

8. Recent policy actions have reinforced a general decline of interest rates along the yield curve. Yields on short to medium-term securities fell immediately after the adoption of the new policy framework, and have since remained around record lows as the BOJ stepped up purchases of short-term government bills to achieve its liquidity target (see below). Bond markets have also been bullish as financial institutions have continued to shift funds into JGBs, and the weakening economic outlook has added to downward pressures on yields. The government’s move to concentrate medium-term issues on the 5-year maturity has led to a sharp yield decline in that segment, with record lows below 0.4 percent reached in June. The 10-year JGB yield also dropped to its lowest level in almost three years after the BOJ’s policy measures in March, and has remained broadly around 1.15 percent since (Figure III.1). Bank deposit and lending rates have also fallen back to record lows reached last summer. Rates were already reduced after the February rate cut, and banks have now reduced interest rates on regular savings deposits from 0.1 percent to 0.02 percent, while the short-term prime rate has declined from 1.5 percent to around 1.375 percent.

uA03fig01

Japan: Yield Curves 1/

Citation: IMF Staff Country Reports 2001, 221; 10.5089/9781451820621.002.A003

Sources: Nikkei Telecom; and WEFA.1/ The graph shows the overnight call rate, 3-, 6-, and 12-month Euro yets rates, and government bond yields from 3 to 10 years.
Figure III.1.
Figure III.1.

Japan: Selected Interest Rates, 1995–2001 1/

Citation: IMF Staff Country Reports 2001, 221; 10.5089/9781451820621.002.A003

Source: Bank of Japan, Economic Statistics Monthly.1/ End-period.

9. Funding conditions for the corporate sector appear to have eased since the return to ultra-low interest rates (Figure III.2). Large parts of the corporate sector are still in the process of deleveraging, and issues of corporate securities in 2000 fell to their lowest levels in more than 5 years. Following the BOJ’s recent policy measures, however, brisk demand for higher-yielding financial instruments has contributed to a more than 40 percent year-on-year increase in straight corporate bonds issued in April and May. The strong demand, combined with a still relatively limited supply of corporate debt, has continued to push risk premiums well below historical levels. The spread on short-term commercial paper rose from about 5 basis points to 30 basis points after the August 2000 rate hike, but has since returned to almost zero. Premia on long-term corporate bonds, while broadly unchanged over the past year, are also substantially below those in other countries. For example, a spread of 20 basis points on a 10-year AA-rated bond by a Japanese issuer compares to about 150 basis points paid by the same issuer in the United States.

Figure III.2.
Figure III.2.

Japan: Funding Conditions for the Domestic Nonfinancial Sector

Citation: IMF Staff Country Reports 2001, 221; 10.5089/9781451820621.002.A003

Source: WEFA, Nomura database.1/ Twelve-year AA class industrial bond yield minus ten-year government bond yield.2/ Three-month commercial paper minus three-month repo (Gensaki rate).

10. Despite the recent monetary easing, monetary conditions do not appear excessively easy by past standards (Figure III.3). While underlying price deflation has indeed worsened, real rates remain substantially higher than during the past four years, with long-term yields closing the gap with the United States that persisted for several years.5 By contrast, the depreciation of the yen (to around ¥120–125 per U.S. dollar) has provided some boost to economic activity in recent months, with the ULC-based real effective exchange rate dropping by 15–20 percent since last fall. This has helped push the overall monetary conditions index (MCI) into weaker territory, although the MCI is only slightly lower than in the first half of 2000 when the economy looked considerably stronger.

uA03fig02

U.S.-Japan: Real Government Bond Yields 1/

Citation: IMF Staff Country Reports 2001, 221; 10.5089/9781451820621.002.A003

Sources: Nikkei Telecom and IMF, CEI Database.1/ Ten year government bond yields minus CPI inflation (adjusted for consumption tax).
Figure III.3.
Figure III.3.

Japan: Monetary Policy Stance, 1995–2001 1/

Citation: IMF Staff Country Reports 2001, 221; 10.5089/9781451820621.002.A003

Sources: Nikkei Telecom; WEFA; and staff estimates.1/ Ten-year government bond yield minus three-month Gensaki rate.2/ Deflated by CPI adjusted for changes in indirect taxes and administered prices.3/ Deflated by core CPI (excluding food and energy) adjusted for changes in indirect taxes and administered prices.4/ An increase Indicates a tightening of monetary and financial conditions. The MCI is a weighted average of changes in the real interest rate and the real effective exchange rate. The FCI also includes the change in the fiscal stance and the stock price index; this index is presented on an annual basis because quarterly fiscal data are not available.

C. Money and Credit

11. Underlying monetary base growth weakened in 2000. Base money declined by ¥18½ trillion during 2000, particularly during the first two quarters of the year as Y2K operations (and possibly some financing bill purchases related to foreign exchange interventions) were unwound (Table III.1). While there was relatively little change during the third quarter, despite the lifting of the zero-interest rate policy (which led to some outflow of excess reserves from the BOJ), the monetary base expanded again in the fourth quarter as the BOJ injected ¥10 trillion worth of liquidity to prepare for the introduction of RTGS.6 Once the effect of transactions spanning the year-end is excluded, however, underlying base money growth appears to have dropped markedly to 4–5 percent year-on-year in the second half of 2000 (Figure III.4). This level was last reached during a period of financial turbulence in 1998 that preceded the introduction of the zero-interest rate policy.

Table III.1.

Japan: Monetary Base and the Bank of Japan’s Transactions (Flow Table)

(In billions of yen)

article image
Source: Bank of Japan, Financial and Economic Statistics Monthly.
Figure III.4.
Figure III.4.

Japan: Monetary Base

Citation: IMF Staff Country Reports 2001, 221; 10.5089/9781451820621.002.A003

Source: Bank of Japan, Financial and Economic Statistics (Monthly).1 Average outstanding.

12. Trends so far in 2001 indicate that the new policy framework has not had a large impact on monetary base growth. Overcoming a temporary contraction in early 2001 (related to the unwinding of liquidity injections over the year-end), monetary base growth accelerated somewhat during the first half of 2001, reaching about 7½ percent in June, similar to the rate in the first half of 2000. Nevertheless, liquidity needs appear to be broadly satisfied, as indicated by the BOJ’s difficulties in meeting its reserves target through repo operations (gensaki) in April and May. A number of money market auctions suffered from a shortfall of bids, which prompted the BOJ to increase its outright purchases of short-term government securities, accounting for more than ¥18 trillion in transactions during the second quarter. Moreover, to facilitate money market operations and liquidity management, the BOJ in May extended the range of instruments for its open market transactions to include six-months commercial bills and a range of medium-term government bonds. It also increased the number of counterparts for its bill purchasing operations, and the increment of bids at monetary auctions was lowered from 1 basis points to one tenth of a basis point.

13. Broad money growth (M2+CDs) has picked up somewhat since hitting a 5-year low last August, but remains constrained by banks’ continuing reluctance to extend credit. The pace of decline in bank lending has slowed to about 4 percent in May, following a trough of 6 percent in early 2000, but claims on the private sector have now been consistently shrinking since 1999 (Table III.2, Figure III.5). By contrast, claims on the government have risen sharply over the same period, reflecting the shift of bank funds into the JGB market. At the end of 2000, banks’ claims on the government were 40 percent higher than the year before, following a 25 percent increase in 1999. Net foreign assets also grew by a quarter during 2000, which contributed almost 2 percent to overall broad money growth.

Table III.2.

Japan: Monetary Survey

article image
Source: Bank of Japan, Financial and Economic Statistics Monthly.
Figure III.5.
Figure III.5.

Japan: Money and Credit Growth, 1995–2001

Citation: IMF Staff Country Reports 2001, 221; 10.5089/9781451820621.002.A003

Sources: Bank of Japan, Economic Stastistics Monthly.1/ End-period.2/ Period average.

14. Growth rates of other monetary aggregates have remained similarly subdued:

  • In line with base money growth, narrow money (M1) expanded strongly in 1999 through mid-2000, but is now recovering only slowly from a sharp deceleration in late 2000.

  • Growth in M3+CDs has fallen to below 1 percent in May, likely reflecting the maturation of postal savings deposits which are partly flowing out of the banking system.

  • Broadly-defined liquidity has expanded at a more stable pace, but its current growth rate of 3 percent is also somewhat lower than in recent years.

15. Money multipliers have been relatively stable over the past two years. Excluding the volatile movements in money multipliers caused by Y2K and RTGS-related liquidity injections (as well as end-FY1999 concerns), broader monetary and liquidity aggregates have exhibited a relatively stable trend relative to reserve money since 1998 (top panel of Figure III.6).7 This would be consistent with the view that the government’s bank support packages in 1998/99 were successful in shoring up confidence in the banking system as a whole, and that “new” financial intermediaries (e.g., security investment trusts and other nonbanks) are only slowly increasing their share in financial intermediation.8

Figure III.6.
Figure III.6.

Japan: Developments in Money Multipliers, 1990–2001 1

Citation: IMF Staff Country Reports 2001, 221; 10.5089/9781451820621.002.A003

Source: Bank of Japan, Financial and Economic Statistics (Monthly).1 End of period.

16. Within broadly-defined liquidity components, some reallocation of funds away from monetary assets appears to be underway. The attractiveness of time deposits and CDs appears to have suffered in recent years, as evidenced by the decline of the share of quasi-money in broad money (middle panel of Figure III.6). However, these funds are no longer flowing into broader M3 components (e.g., deposits in the postal system, cooperative-type institutions, or trust money in domestic banks), which they did during most of the 1990s.9 Instead, nonmonetary items that are still part of broadly-defined liquidity (e.g., investment trusts held in banks, JGBs held by non-banks, etc.) have recently risen faster than M3 components, which seems to be a consequence of the higher relative returns offered by such instruments (lower panel of Figure III.6).

D. Outlook

17. The new policy framework provides the BOJ with the scope to ease the policy stance further. The expansion of reserve balances by around ¥1 trillion has been maintained through repo operations and purchases of short-term government securities, and the BOJ has so far seen no need to step up JGB purchases. The BOJ’s commitment to keep the policy in place until deflation has been eliminated appears to have had its desired effect, as markets are expecting short-term interest rates to remain at their floor for quite some time (as indicated, e.g., by the flattening of the yield curve and the decline in Euroyen futures). However, most market participants take the view that the BOJ will need to do more to eliminate deflation within a reasonable timeframe, which underscores the need for making use of the flexibility afforded by the new policy framework.

uA03fig03

Japan: Three-Month Euroyon Futures 1/

Citation: IMF Staff Country Reports 2001, 221; 10.5089/9781451820621.002.A003

Source: Bloomberg LP.1/ Based on futures prices which reflect term and liquidity premia, as well as expected future three-month interest rates.
1

Prepared by Martin Mühleisen (ext. 38686).

2

The BOJ interpreted the decline in nominal price indices as a side-effect of significant structural change in the economy (“good” deflation), rather than a lack of aggregate demand (see On Price Stability, a BOJ report published in October 2000).

3

The new facility became operative on March 16, 2001.

4

To streamline its money market operations, the BOJ has since abolished the discounting of commercial bills, the Import Bills Refinancing Facility, and the Lending Facility at a Non-basic Loan Rate. The main remaining function of the basic loan rate will thus be to reduce interest rate volatility by putting an effective ceiling on the overnight call rate.

5

Real rates were sharply lower around the turn of the year (see middle panel of Figure III.3), but this remained temporary as a surge in energy prices subsequently reversed itself.

6

The liquidity injections at the end of the year were conducted almost exclusively through repo operations. By comparison, the much larger operations needed to address Y2K concerns—involving close to ¥30 trillion in liquidity—consisted mostly of so-called “dual” operations (in which the BOJ purchased government securities spanning the year-end and withdrew overnight funds through the sale of BOJ bills). These developments are mirrored in the size of the BOJ’s balance sheet.

7

Reflecting inter alia problems in the banking sector, money multipliers have generally declined during the 1990s.

8

The slow growth in importance of “new” intermediaries is confirmed by the recently released flow of funds statistics for FY1999 (see BOJ Quarterly Bulletin, February 2001).

9

For example, with the maturation of high-yielding teigaku deposits, the share of postal savings deposits in broadly-defined liquidity has fallen from 20¾ percent in early 2000 to 19 percent in April 2001.

Japan: Economic and Policy Developments
Author: International Monetary Fund