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Box 2. Policy commitment to ending deflation

Box 2. Policy commitment to ending deflation

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62



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



Bringing deflation to an end



63



firms continue to perform poorly after receiving additional loans. As a result, the

tendency to supply credit to the companies that are relatively less productive

weakens the prospects for growth and slows corporate restructuring. The pricecutting behaviour of these weak but protected firms also tends to increase deflationary pressure while hurting viable firms. In addition, supplying capital to weak companies undermines the long-run prospects for the banks by slowing the development of

a more dynamic client base. This has been a serious problem in the past and although

the introduction of stricter assessment of asset quality has helped improve the

situation, problems still exist. In sum, while the poor macroeconomic performance is

a fundamental cause of financial-sector weakness, problems in this sector are a

factor blocking the prospects for growth. A recovery in lending by banks, which

remain the dominant players in the Japanese financial system, is a necessary

condition for a robust and sustainable expansion.

The non-performing loan problem has undermined the financial health

of the banking sector

The banking sector has not achieved a net operating profit since FY 1992.

During the 1990s, though, the banks were able to offset about two-thirds of their

cumulative operating losses with capital gains from the sale of equities and land

purchased prior to the bubble period. Such gains enabled the banks to avoid net

losses in all but three years during the 1990s (Figure 21), although this did not prevent the failure of a number of banks, including three large ones. However, the

scope for capital gains had been largely used up by the end of the 1990s. With realised capital gains turning negative in FY 2001 and FY 2002, the banking sector has

become increasingly vulnerable. Indeed, net losses amounted to almost 10 trillion

yen (2 per cent of GDP) during the past two years. Such losses occurred despite

the quantitative easing policy of the Bank of Japan, which has supported bank

profitability by supplying abundant liquidity at interest rates close to zero.

The consistent net operating losses are fundamentally due to the nonperforming loan problem, which has imposed 87 trillion yen (17 per cent of 2002

GDP) in loan losses on the banks since 1993 (Table 5). Although gross operating

profit has been on a slight upward trend since FY 1999, it remains less than loan

losses. Such losses reflect weak economic conditions and the more rigorous application of loan standards, which tend to boost the amount of provisioning required.

The stricter self-assessment of assets has been accomplished in part through the

FSA’s special inspections of the classification of large borrowers in 2002 and 2003.

The second round of special inspections covered 167 borrowers, including

142 that were included in the first round in 2001 (see the 2002 Survey), with total

loans of 14.4 trillion yen from the 11 major banks. It covered most of the large

companies that have seen their share prices or credit ratings plunge. As a result of

the discounted cash flow method of provisioning introduced by the Programme for



© OECD 2004



OECD Economic Surveys: Japan



64



Figure 21. Profitability in the Japanese banking sector

Trillion yen



Trillion yen



15



15

Gross operating profit

Capital gains1

Loan losses

Net profit



10



10



5



5



0



0



-5



-5



-10



-10



-15



1990



1991



1992 1993



1994 1995



1996



1997 1998



1999 2000



2001



2002



-15



1. On equities and real estate.

Source: Fukao (2003).



Financial Revival, banks were obliged, according to a tentative calculation by the

FSA, to boost provisions by 500 billion yen while writing off 800 billion yen worth

of non-performing loans related to borrowers reviewed in this special inspection.

A total of 2.4 trillion yen – 17 per cent of the loans investigated – were downgraded,

a relatively small proportion compared to the first round when the share was more

than one-half. This indicates that the banks’ assessment of loans is gradually

converging to that of the FSA, a conclusion supported by the FSA’s regular inspection.34 More than 90 per cent of the downgraded loans were in wholesale and retail

trade, construction, real estate and financial services other than banks.

The large loan losses and declining equity prices reduced the capital

base of internationally-active banks by more than 11 per cent during the year to

March 2002 (Table 6). With capital shrinking, banks have been forced to cut lending to accelerate the disposal of non-performing loans and to protect the soundness of their balance sheets. Despite an 8 per cent fall in risk-adjusted assets

during the year to March 2002, the ratio declined from 11.0 to 10.6 per cent. Given

that equity holdings are about a quarter higher than tier I capital, fluctuations in

the stock market put the banks at risk of falling below the 8 per cent threshold. In

addition to the declining quantity of capital, there is also concern about its quality.

First, the life insurance industry, another troubled part of the financial sector, and

the banking sector are important providers of capital to each other, creating a



© OECD 2004



Trillion yen

Financial year



Lending margin (A)

Other revenue (B)2

Operating costs (C)

Salaries and wages

Gross operating profit

(D) = (A) + (B) – (C)

Loan loss (E)

Net operating profit

(F) = (D) – (E)

Realised capital gains (G)3

Net profit (F) + (G)

Assets

Outstanding loans



1990



1991



1992



1993



1994



1995



1996



1997



1998



1999



2000



2001



2002



7.1

2.6

7.1

3.7



8.9

2.2

7.5

3.9



9.8

2.5

7.7

4.0



9.2

2.8

7.7

4.0



9.7

2.1

7.8

4.0



10.8

3.3

7.8

4.0



10.7

3.7

8.0

4.0



10.0

3.6

8.0

4.0



9.6

3.1

7.5

3.6



9.7

2.5

7.3

3.5



9.4

3.0

7.1

3.4



9.8

3.1

7.0

3.2



9.7

3.2

6.8

3.0



2.6

0.8



3.5

1.0



4.5

2.0



4.3

4.6



4.0

6.2



6.3

13.3



6.4

7.3



5.6

13.5



5.2

13.5



4.9

6.3



5.3

6.6



5.9

9.4



6.0

6.6



1.8

2.0

3.8



2.5

0.7

3.3



2.5

0.0

2.5



–0.4

2.0

1.7



–2.2

3.2

1.0



–7.0

4.4

–2.6



–1.0

1.2

0.2



–7.9

3.6

–4.2



–8.3

1.4

–6.9



–1.4

3.8

2.3



–1.3

1.4

0.1



–3.5

–2.4

–5.9



–0.6

–4.1

–4.7



927.6

522.0



914.4

537.0



859.5

542.0



849.8

539.0



845.0

539.0



848.2

554.0



856.0

563.0



848.0

536.0



759.7

492.0



737.2

476.0



804.3

474.0



772.0

465.0



751.4

440.4



Bringing deflation to an end



© OECD 2004



Table 5. The balance sheet of the Japanese banking sector1



1. All commercial banks.

2. Other revenue (B) includes all other profits such as dealing profits and fees, but excludes realised capital gains on equities and real estate.

3. Realised capital gains include gains from equities and real estate.

Source: Fukao (2003) and Bank of Japan, Monthly Report, August 2003.



65



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Box 2. Policy commitment to ending deflation

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