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76



OECD Economic Surveys: Japan



under which the authorities might take this step include a failure to pay dividends

on preferred stock for two consecutive years, steep declines in a bank’s earnings,

under-capitalisation and failure to improve performance after the implementation

of corrective measures. The strengthened role of auditors should also improve the

governance of banks since they are required to express an opinion on whether an

institution qualifies as a “going concern”.

Problems in the life insurance sector

The health of the banking sector is linked to that of the life insurance companies, the second largest part of the financial sector, with assets amounting to

about 30 per cent of GDP. The two sectors are important providers of capital to

each other. Indeed, the insurers are major shareholders of the banks, owning more

than 10 trillion yen in bank equity and subordinated debt in 2001. The banks, in

turn, are significant purchasers of the subordinated debt and surplus notes of the

insurance companies. As a result of this “double-gearing”, the weakness in the life

insurance industry has implications for the banking sector, in addition to being

important in its own right.50 Double-gearing results in poor-quality capital, thus

raising systemic risk. If a major life insurer goes bankrupt, the banks that provided

funding to it will lose money, prompting a fall in the stock prices of those banks.

This would, in turn, reduce the assets of the insurance companies holding those

bank stocks (Fukao, 2003).

The life insurance industry has also experienced severe problems, as evidenced by the failure of seven of the major 20 companies since 1997, while seven

other companies have entered into alliances with foreign investors. Solvency

ratios fell sharply for most companies in FY 2002 and a number cancelled dividend payments to policyholders. The problems facing life insurance companies

are similar to those of the banks in many respects: non-performing loans, significant exposure to the stock market and competition from government financial

institutions. Indeed, the Postal Insurance System accounts for 40 per cent of the

assets in the life insurance sector. In addition, premium income has been cut by

policy cancellations and a decline in new policies by households, who are wary of

the financial weakness in this sector. However, the key problem is that in the

higher interest rate environment in the past, the life insurance industry promised

returns to policymakers that turned out to be unrealistically high, due to the fall in

interest rates and the weak stock market. By 2002, the difference between what

the life insurers had promised to pay and the current yield – the “negative carry” –

had reached 1.25 trillion yen. To solve this problem and protect policyholders, the

Diet passed a bill in July 2003 that allows the companies to cut guaranteed yields

on existing policies even if the companies are not on the verge of bankruptcy.

Such reductions, though, require the approval of both the authorities and policyholders. Banks that provided capital to the life insurance company would also



© OECD 2004



Bringing deflation to an end



77



have to bear a portion of the financial pain. However, life insurance companies

may be reluctant to request cuts in yields, fearing that it would spark a surge of

cancellations by policyholders. Indeed, previous attempts to introduce such a

measure prompted an angry response from policyholders.

Assessment

Bringing deflation to an end is the top priority for the monetary authorities. The current quantitative easing policy should be strengthened in several

respects. First, the range of assets purchased by the BOJ should be broadened.

Such a move would reinforce the impact of quantitative easing and alleviate the

exit problem when inflation returns. For the medium term, a solid framework for

monetary policy management needs to be established to contain risks of both

overshooting and undershooting the optimal inflation rate. Given the large slack in the

economy, such a framework should include a commitment to reduce the possibility of

returning to deflation by pledging to continue easing for a longer period than otherwise required and by allowing a temporary deviation from the desired level of

inflation until such a risk diminishes. The BOJ’s recent clarification of its commitment

to continue the quantitative easing policy is welcome in this regard. The level of the

medium-term target for either inflation or the price level also needs to be sufficiently

high to limit the risk of falling back into deflation. Purchasing a broader range of assets

would boost the credibility of the commitment of the BOJ to stopping deflation since

inflation would likely generate capital gains on those assets.

Ending deflation will also require simultaneously resolving the problems

in the banking sector that have prevented the monetary transmission mechanism

from functioning. While some observers have argued against rapid financial-sector

restructuring on the grounds that it would worsen economic conditions and raise

the risk of a deflationary spiral, it is clear after a decade of stagnation that decisive

action is needed. Time has not only failed to solve the problems, it has made

many of them worse. The authorities recognised the urgency in its October 2002

plan for financial-sector restructuring. The progress achieved in implementing this

plan is encouraging and should be accelerated.

In particular, the weakness of capital is forcing banks to shrink their loan

books to protect the soundness of their balance sheets. While it is important that

banks obtain more capital from the markets, the authorities should not allow the

banks’ efforts in this regard to influence their lending policies, while guarding

against double-gearing. Moreover, capital regulations should impose meaningful

standards. In particular, a stricter evaluation of deferred tax assets and a lower

ceiling on their maximum amount should be applied to all banks so that reported

capital levels accurately reflect their economic strength. The fact that a recent

audit found that deferred tax assets were unrealistically high at a major bank suggests that this is an important problem for financial regulation. This discovery



© OECD 2004



78



OECD Economic Surveys: Japan



forced the bank, Resona, to seek public funds, making the government the major

owner and giving it a chance to make Resona a model of reform. However, the

decision to impose a quota on lending to SMEs, which already accounts for threequarters of Resona’s loans, is doubtful from an economic point of view. Moreover,

it is essential to make clear that this is the last re-capitalisation using public funds

for this bank.

Given the size of the banking-sector problem, a clear framework for using

public funds is needed to re-capitalise banks before they reach critical condition. In

dealing with weak banks, the benefits of salvaging information about borrowers and

maintaining credit flows in the short run provide potential rationales for injecting

public funds. However, given the excess capacity existing at present, the downsizing

of the banking sector would boost the profitability of stronger banks. Thus, government assistance should be selective, particularly in the context of the difficult fiscal

situation. Moreover, a new framework for the injection of public funds into banks

should take into consideration market signals in deciding which banks to support.

For example, those that cannot attract private financing should receive lower priority. In addition, assistance should be conditional on effective reform of risk management and reduction of non-performing loans in line with the targets set in 2002.

Meeting the targets for reducing the stock of non-performing loans, based

on strict loan classification, should be a priority. Greater use of forward-looking criteria for loan classification and provisioning is essential during a period of very

low interest rates, and should be combined with improved supervision. The sale

of non-performing loans and corporate restructuring should also be accelerated by

the RCC and the IRC. It is important that these publicly funded organisations

impose market discipline in their loan repurchases and restructuring efforts in order

to avoid moral hazard problems and allow them to break even financially, thus

avoiding additional burdens for taxpayers. The IRC’s role is complicated by the different priorities between itself and the banks in the selection of companies. While

the IRC prefers companies strong enough to recover and have a significant economic

impact, the banks would rather sell the loans of weak companies. Some initial successes will be needed to win the confidence of banks in the IRC, which hopes to

handle up to 100 firms. Success in speeding up the disposal of non-performing

loans and the pace of corporate restructuring would have a negative short-run

impact on employment and output. However, the closure of non-viable firms, who

often pursue price-cutting strategies, would reduce deflationary pressure.

Finally, boosting the low profitability of the banking sector is essential to

cope with the problems of high non-performing loans and under-capitalisation.

Reducing capacity through the exit of weak institutions would be beneficial in this

regards. Perhaps most importantly, the growing role of government financial institutions, which reduce the ability of private banks to compete, should be scaled back.

Improving the governance of banks is another key to boosting profitability.



© OECD 2004



III. Achieving fiscal sustainability

The deterioration of the fiscal situation has continued, with the general

government deficit rising to a projected 7¾ per cent of GDP in 2003 and public debt

soaring to more than 150 per cent. The large budget deficit mainly reflects weak

economic conditions, which outweigh the authorities’ consolidation efforts to date.

The government is trying to reduce the deficit by keeping the level of expenditures

constant as a share of GDP but, with deflation eroding the tax base, shortfalls in

revenue have prevented progress thus far. One positive development is the fiscal

reform initiatives launched during the past several years, which have improved the

allocation of spending, thus boosting the efficiency of public expenditures.

Given the size of the deficit and the substantial increase in public debt, the

sustainability of fiscal policy is a serious concern. However, the financing of the public

debt is very stable as indicated by the exceptionally low long-term interest rate in

Japan. Indeed, the extreme risk aversion of investors and the persistence of deflationary expectations pushed up bond prices to a record high in June 2003. This

reduces interest payments by the government, facilitating the rollover of the public

debt. Nevertheless, concerns about fiscal sustainability remain strong among

households as unfavourable demographic factors are expected to add further pressure on spending. The government has introduced a Medium-term Economic and Fiscal

Perspective, which aims at achieving a primary budget surplus in the early 2010s.

The biggest challenge facing the authorities is thus to ensure fiscal sustainability in the uncertain economic environment prevailing at present. This

requires bold actions to defeat deflation and to lead the economy to a more

normal growth path. At the same time, a credible medium-term fiscal consolidation programme, which includes concrete plans, needs to be established. Achieving

these difficult and in some respects contradictory goals will require a carefully

designed strategy to ensure consistency between short and longer-term objectives. The first section of this chapter updates recent developments in fiscal policy

and assesses the current policy stance. The second part focuses on whether fiscal

policy is sustainable and then discusses how sustainability can be ensured over

the longer term. The final section provides an overall assessment of fiscal policy in

both the short and longer term.



© OECD 2004



OECD Economic Surveys: Japan



80



Figure 25. Government expenditure and revenue trends

Annual average percentage change in nominal terms

10



10

1990-1995

1996-2002



5



5



0



0



-5

Total spending Social security

paid



Interest

payments



Public

investment



Tax revenue



-10



Net lending1



-5



-10



1. Net lending is presented as a share of GDP.

Source: Cabinet Office, National Accounts and OECD estimates.



Recent developments in fiscal policy: the deterioration continues

The worsening fiscal conditions over the past decade reflect strong pressure for increased social security-related spending and the continued decline in

tax revenues (Figure 25). The latter is due to both major tax reductions in

the 1990s and the weak economy. In particular, deflation has squeezed the nominal

income of households and companies, thus reducing tax revenue. The growth of

spending is mainly driven by the rapid ageing of the population, despite a series

of reforms of the social security schemes. In contrast, interest payments by the

government have fallen since 1996, despite the sharp surge in public debt, thanks

primarily to lower interest rates. On the other hand, a large increase in public

investment during the first half of the 1990s was substantially unwound in the second

half of the decade. Falling public investment has helped keep total government

expenditures constant over the past several years in nominal terms. However, with

continued weakness in tax revenue, this has not been sufficient to reduce the

budget deficit.

The FY 2002 budget outcome turned out to be expansionary

The initial central government budget for FY 2002 was intended to limit

the reliance on public bonds to 30 trillion yen, the level issued in FY 2001. Achieving this target – which ruled out any supplementary budgets – was expected to



© OECD 2004



Achieving fiscal sustainability



81



lead to a tightening of fiscal policy relative to the outcome of the FY 2001

budget, which had included two supplementary budgets.51 However, a significant weakening in the momentum of the economic recovery during the course

of 2002 and a sharp fall in share prices led the government to announce an

economic and structural reform package in October 2002. The package

consisted of measures to expand the social safety net, accelerate the resolution of non-performing loans, prevent a credit crunch, implement further regulatory reforms and introduce front-loaded tax cuts. Since some of the measures

in the package required additional budget outlays, the government

announced in December a supplementary budget that was subsequently

passed in January 2003. That budget provided 4.2 trillion yen of additional

expenditures, in part for the social safety net and public investment, which

was partially offset by 1.7 trillion yen of budget savings (Table 9). The

2.5 trillion yen net rise in spending was accompanied by a tax shortfall of the

same amount, boosting the financing cost of the supplementary budget to

5 trillion yen (1 per cent of GDP). Rather than resort to creative accounting as

in the previous year, the government allowed public bond issuance to exceed

the 30 trillion yen ceiling, thus improving budget transparency. Overall, the

fiscal stance in FY 2002 turned out to be slightly expansionary.



Table 9. The FY 2002 budget

Trillion yen, general account of central government

Expenditures



Initial budget

Supplementary budget

(December 2002)



Revenues



81.2

Total, net

Increased spending:

Safety net

Employment

SMEs

Other

Public investment

Mandatory spending



2.5

4.2

1.5

0.5

0.5

0.5

1.5

1.2



Decreased spending:

Mandatory spending

Local transfers



–1.7

–1.2

–0.5



Tax revenue



Borrowing



51.2



30.0



–2.5



5.0



Total FY 2002 budget



83.7



48.7



35.0



(Reference)

FY 2001 budget including

supplementary budgets



86.4



53.71



32.52



1. Tax revenue totalled 49.6 trillion yen.

2. Includes 2.5 trillion yen of borrowing from a special account.

Source: Ministry of Finance.



© OECD 2004



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