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Figure 24. Interest margin on lending
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
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.
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
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
Figure 25. Government expenditure and revenue trends
Annual average percentage change in nominal terms
Total spending Social security
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
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
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
Total FY 2002 budget
FY 2001 budget including
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