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Table 4. Compostion of banks’ assets

Table 4. Compostion of banks’ assets

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OECD Economic Surveys: Japan


Finally, the impact of the current quantitative easing on the yen is rather

ambiguous as the exchange rate is affected by many factors. With the zero constraint

on nominal interest rates, the real interest rate remains significantly positive in the

context of deflation. Interest parity conditions, therefore, do not necessarily favour

depreciation. As discussed earlier, the shift of funds to foreign financial markets did

not lead to a weaker yen. After the BOJ adopted the quantitative easing approach in

March 2001, the yen weakened by 6 per cent from 125 yen per US dollar to 133 yen

in February 2002. However, this was more than offset by an appreciation of 12 per

cent to the level of 119 yen by August 2002. After stabilising at around that level for a

year, the yen appreciated further to about 110 yen at the end of September 2003.

The BOJ intervened actively as an agent of the Ministry of Finance in the second

quarter of 2002 and in the first three quarters of 2003 when speculative movements

were observed in the exchange market. The amount of intervention reached

4 trillion yen (0.8 per cent of GDP) in 2002 and nearly 13.5 trillion yen (2.7 per cent of

GDP) during the first nine months of 2003.

In conclusion, the above analysis indicates that the quantitative easing

policy to increase the monetary base has had only a limited positive impact on

the economy for a number of reasons:

– The portfolio rebalancing effect has been weak due to the low opportunity cost of holding liquid assets, financial-sector fragility that has

boosted precautionary holdings of cash and the reluctance of households

and financial institutions to take risks.

– The credit channel has broken down.

– Quantitative easing has failed to have a significant impact on the

exchange rate.

Meanwhile, the current monetary policy strategy based on increased purchases of

long-term government bonds to achieve the quantitative target is attracting

private-sector purchases in this market. This creates a risk that financial institutions will incur huge capital losses on their bond holdings once deflation ends,

thus complicating the exit strategy. The BOJ is now pursuing measures to restore

the credit channel by helping banks through purchasing shares they hold and by

supporting the finance of SMEs by fostering asset-backed securities and commercial paper markets. But the question remains whether such a strategy, combined

with measures to accelerate the resolution of non-performing loans, can restore

sustainable growth of nominal income in the near future.

How can monetary policy contribute to restoring sustainable growth

of nominal income?

Given the zero bound on interest rates and the difficulties in the banking

sector that constrain the effectiveness of monetary policy, the monetary authorities

© OECD 2004

Bringing deflation to an end


have often stated that their available policy tools have already been exhausted.

Nonetheless, a variety of alternative tools have been suggested, including: taking

direct or indirect measures to raise asset prices to supplement portfolio rebalancing

by the private sector; changing the foreign exchange regime to boost the

economy; and influencing expectations of future inflation in order to reduce real

interest rates.

As discussed in past Economic Surveys, one way to reinforce the current

quantitative easing scheme is for the BOJ to purchase a broader range of assets.

This might encourage the shift of private funds to more risky assets, which, in turn,

would stimulate the economy. Higher asset prices could also alleviate a major

constraint on the credit channel by decreasing external financing costs for borrowers through higher value for collateral. Indeed, the central bank has already taken

a step in this direction by purchasing shares held by private banks. Although its

main purpose is to reduce the excessive shareholding by banks for prudential

reasons, this operation effectively helps avoid possible downward pressure on

share prices that would result if banks sold those shares in the market. The recent

decision by the BOJ to purchase ABS and ABCP could also accommodate portfolio

rebalancing by small businesses by increasing their investment capacity or

encouraging them to buy other assets. It would be useful for the central bank to

purchase securitised assets such as Exchange-Traded Funds (ETFs), which are

based on a stock price index, and Real Estate Investment Trusts (REITs), as such

operations could affect prices of real assets with less distortive effects on the

relative prices of the underlying specific assets. Since the securitised assets are a

closer substitute to liquid assets than the underlying real assets themselves, the

development of such financial products, whose markets are currently small, could

encourage the shift of funds held by households and financial institutions. That

implies that the size of BOJ purchases needed to achieve a significantly positive

impact may not be necessarily large. One of the advantages of this option compared to the current framework is that it could alleviate the exit problem to some

extent since the prices of these real assets are likely to increase when inflation

expectations rise. This is in sharp contrast to the current strategy of purchasing

mainly JGBs, which are likely to experience price declines when deflation comes

to an end.27 However, given the limited size of the securitised asset markets, the

purchase of such assets alone would not be able to offset the impact of a possible

decline in bond prices accompanied by higher inflation expectations.

It is often argued that one of the easiest ways out of deflation would be to

let the exchange rate depreciate (McCallum, 2001 and Svensson, 2000). Although a

fall in the yen would alleviate deflation by stimulating the economy and by driving

up import prices, the key question is how to generate desirable depreciation and

how to keep the exchange rate at the appropriate level. One possibility is massive

intervention in foreign exchange markets. Such intervention can be funded by

printing more currency and hence does not require the use of foreign reserves. It

© OECD 2004


OECD Economic Surveys: Japan

has also been argued that depreciation of the yen could be achieved by setting a

price level target in order to generate expectations of currency depreciation and

then pegging the exchange rate at the lower level. However, such a strategy could

generate negative reactions from other countries, preventing the positive effects

from being realised. In sum, currency depreciation would likely require a multilateral approach. As noted above, the active official intervention in 2002 and the first

nine months of 2003 has been conducted against speculative movements in the

exchange market. This approach is successful in stabilising the exchange rate

when there is pressure for appreciation.

Another widely discussed option is for the BOJ to commit to a specific

inflation target. However, it is difficult to establish a credible commitment to any

specific inflation target since the unpredictability of the transmission mechanism

and the ineffectiveness of policy instruments makes it very uncertain how the

objective could be achieved (see the 2002 Survey). As noted above, the constraints

on the transmission mechanism limit the expected impact of monetary policy at

present. As these obstacles are overcome, the BOJ needs to have a clear framework for monetary policy management so as to prevent both overshooting and

undershooting of the optimal inflation rate. This is particularly important as the

markets begin to worry about the possible end of quantitative easing, given the

on-going recovery. One risk is that the large amount of reserves at present, which

far exceed the necessary level, could generate hyperinflation. On the other hand,

an excessively tight policy would eliminate inflationary pressure at an early stage,

pushing the economy back into deflation. Given the existence of large slack in the

economy, the latter risk probably outweighs the former at present.

Consequently, the monetary framework needs to have a strong commitment to reduce the risk of returning to deflation and should allow some temporary

upward deviation from the desired level of inflation as long as such risks remain.

One option would be to pledge to continue monetary easing for a longer period

than otherwise required. It could take such forms as setting the interest rate below

the level suggested by the Taylor rule or promising to continue the zero interest

rate policy.28 Such a commitment could slow the rise in long-term interest rates

and generate stronger stimulus to the economy once inflation expectations turn

positive. In this regard, the BOJ recently clarified its commitment to continue the

quantitative easing policy by specifying two necessary conditions for policy change.29

Furthermore, it suggests that it could continue the quantitative easing policy in certain

circumstances even if those two conditions are met. To further strengthen credibility,

some form of price level target would also be useful (Woodford and Eggertsson,

2003). Since this approach allows a temporary hike or drift in inflation during the

transitional period – in order to allow the price level to catch up to the target level

after a period of deflation – it would strengthen the commitment to inflation. Price

level targeting automatically strengthens the credibility of inflationary policies

when negative shocks arise as a larger gap between the target and the current

© OECD 2004

Bringing deflation to an end


level requires a more aggressive inflationary stance. The level of the long-run target for either inflation or the price level will also need to be sufficiently high.30

According to one study, an economy running at a targeted rate of inflation of zero

is more likely to fall into deflation following a negative shock than an economy

with a higher rate of inflation.31 The measurement errors often attached to the consumer price index and the need for leaving scope for negative real interest rates

also support the desirability of targeting a positive inflation rate. Moreover, given

the possibility of nominal rigidity at very low inflation rates, aiming at an inflation

rate near zero could constrain the flexibility of wage and price adjustments to

demand shocks, possibly amplifying the fluctuation of unemployment and output

(see Box 1).32

The purchase of a broader range of assets, including real assets and foreign assets, would also boost the credibility of the BOJ’s commitment to stopping

deflation (Box 2). A mere pledge to achieve a certain rate of inflation or price level

Box 2. Policy commitment to ending deflation

A number of recent studies focus on the role of expectations in bringing about

positive inflation. The basic idea is that, despite the zero bound on interest rates,

the BOJ can stimulate the economy by generating positive inflation expectations

and thus lowering the real interest rate. A key to such a strategy is to establish the

credibility of the authorities’ commitment to certain goals or policy rules aiming at

positive inflation. One of the pioneering studies (Krugman, 1998) argues that a rise

in the money supply has no effect under liquidity trap conditions as long as the

private sector expects the increase to be reversed in the future. This would suggest

the need for an inflation target in order to change the expectations of private

agents. However, subsequent studies argue that a promise to achieve an inflation

target is ineffective unless it is accompanied by other policy actions that bind that

commitment. Although the central bank has an incentive under the zero bound on

interest rates to commit to an inflation target, when deflationary pressure actually

subsides, the ex post optimal inflation could be below the previously promised

level. This would give the central bank an incentive to renege on its commitment. If

private agents are rational, the inflation target is obviously ineffective when the

authorities have both the capability and the incentive to renege on its commitment

ex post (Eggertsson, 2003). One way to prevent them from doing so is to bind the

commitment with some other policy measures that would punish the authorities if

they were to renege. For example, a tax reduction funded by public bonds or the

purchase of real assets by the authorities could reduce the incentive to renege

since continuing deflation raises the real value of public debt or incurs capital

losses in real assets. Such policies, though, require an agreement between the

central bank and the fiscal authorities, which may be difficult in practice given the

more independent status of the BOJ at present.

© OECD 2004


OECD Economic Surveys: Japan

may not be credible as the central bank might have an incentive to renege on its

ex ante commitment once deflationary pressures subside. At that point, the ex post

optimal inflation rate might be below the earlier targeted level. However, the

purchase of real assets could provide the BOJ with a strong incentive to achieve

the targeted inflation rate since it would otherwise incur significant capital losses.

Although it is often argued that BOJ purchases of risky assets would inevitably

raise the potential fiscal cost stemming from capital losses of the central bank, the

BOJ’s incentive to minimise the fiscal costs would strengthen its commitment to

the inflation target. In the same way, the purchase of foreign assets by the central

bank could also have the same binding effect since downward pressure on the

yen, possibly accompanied by higher inflation expectations, would generate

capital gains from foreign assets.

Improving the health of the banking sector

The failure of the credit channel to function is a key factor that has limited

the impact of the Bank of Japan’s policy of quantitative easing. As noted above,

both demand and supply factors explain why this policy has not been successful

in reversing the decline in bank credit that began in the mid-1990s. It is clear that

demand and supply factors are closely linked and that causality runs in both

directions. Stagnant economic conditions reduce the demand for new loans, as

well as the ability of firms to repay outstanding loans. The result is higher default

rates that undermine the financial health of banks. At the same time, the lending

capacity of banks is limited by the need to protect the soundness of their balance

sheets, causing banks to shrink their volume of risk assets, thus preventing monetary policy from having its full effect. The latter linkage is substantiated by the fact

that banks with higher initial proportions of non-performing loans and lower loanloss reserve ratios recorded the largest declines in credit between 2000 and 2002

(Dell’Ariccia, 2003). Although there is not a credit crunch in an aggregate sense – in

fact the non-financial corporate sector is a net lender – the flow of money into safe

havens is limiting the availability of credit to many potential borrowers, particularly

smaller firms. While total bank lending has fallen by 12 per cent since 1995, lending

to small and medium-sized enterprises has declined by twice that amount.

In addition to the decline in the overall level of lending, the problems in

the banking sector have been slowing growth by skewing the allocation of credit

toward the weakest firms. This comes about through the following mechanism.

Given the banks’ impaired capital base, they have an incentive to extend loans to

their large, but weak, clients in order to avoid recognising additional loan losses

and to maintain their capital levels. This leads to a policy of “ever greening” in

which banks lend to troubled firms in order to prevent or delay bankruptcy. There

is evidence that large companies are far more likely to receive additional credit if

they are in poor financial condition (Peek and Rosengren, 2003).33 Moreover, these

© OECD 2004

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Table 4. Compostion of banks’ assets

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