Lessons from Japan&39;s 30 years financial liberalization

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Future Direction of Financial Liberalization in India

Lessons from Financial Liberalization in Japan: 1970s-20101. 2. Timing of the financial liberalization Interaction between currency y internationalization and financial liberalization Banking sector problem under the distorted financial liberalization Achievements of the Japan’s Financial‘Big Bang’

Lessons from Japan’s Japan s 30 years14 September 2010, New Delhi, IndiaSatoshi Koibuchi Associate Professor of Finance Chuo University

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Lesson 1. 1 What triggered Japan Japan’s s financial liberalization Macroeconomic developments Slowdown of economic growth rate Reduction in corporate p investment& financing g needs Government’s fiscal expansion to offset the output decline mainly by expenditures related to public work and social security system Needs to accommodate find a way to transfer household savings i to t th the government t Liberalization of the government bond market began. Then, Then liberalization of corporate bond market and interest rate decontrol followed.

Real growth対前年度比(%) rate (annual,%)14.0 12.0 10.0 8.0 6.0

Japan’s Postwar Economic Growth Rate: 1956-2006

戦後日本の経済成長率

実質GDP成長率(年率)平均(1973-92年度)=3.7%Oil shockオイルショック (1973) (1973年)

平均(1956-72年度)=9.3%平均(1993-2003年度)=1.2%Collapse of bubbleバブル崩壊ル崩壊 economy (1991年) (1991)

Average: 9.3%

Japan’s‘Lost4.0 2.0Average: 3.7% Actual real growth rate

Decade(s)’失われた10年(15年)

0.0 -2.0 -4.0Average: 1.2%

19 56 19 58 19 60 19 62 19 64 19 66 19 68 19 70 19 72 19 74 19 76 19 78 19 80 19 82 19 84 19 86 19 88 19 90 19 92 19 94 19 96 19 98 20 00 20 02 20 04 20 06

Fiscal year年度

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Percent to%(対名目GDP比) Nominal GDP15.0 10.0 5.0

Net Lender and Net Borrower in Flow of Funds Data非金融法人企業金融機関一般政府家計海外部門

制度部門別資金過不足(対名目GDP比)

Lesson 1. 1 What triggered Japan Japan’s s financial liberalization (2)Households

Fi Financial i l Institutions I tit ti0.0 -5.0 10 0 -10.0

Government

Overseas

Corporations-15.0

Fiscal年 year

Actual timing of financial liberalization Slowdown in economic growth and changing corporate needs are fundamental Significant shocks in 1973 like‘Oil shock’ and the collapse of fixed exchange rate regime in global monetary system were crucial i l to d determine i the h timing i i of financial liberalization Government Government’s s own motivation played crucial role The actual timing does not necessarily match with optimal timing in microeconomic aspects for large corporations, financial institutions, and households.

19 7 19 0 7 19 1 7 19 2 7 19 3 7 19 4 7 19 5 7 19 6 7 19 7 7 19 8 7 19 9 8 19 0 8 19 1 8 19 2 8 19 3 8 19 4 8 19 5 8 19 6 8 19 7 8 19 8 8 19 9 9 19

0 91 19 9 19 2 93 19 9 19 4 9 19 5 96 19 9 19 7 98

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Lesson 2: Interaction between currency internationalization& financial liberalization Enactment of the 1980 reform of the Foreign Exchange and Trade Control Act opened the door for foreign financing and investment opportunities. With the revision, foreign exchanges transactions became“free unless prohibited.” In I 1984, 8 abolition b li i of f the h““real ld demand d principle”, i i l” which hi h required that FX dealings be based on an actual need for payment for imports In 1986, Tokyo offshore market was opened.

Lesson 2: Interaction between Currency internationalization& financial liberalization (2) As a result of abolition of capital control, Japanese corporations satisfying the relevant criteria shift to overseas financing, mostly bond markets, to avoid many regulations in domestic bond markets. Share of foreign bond issuance for Japanese corporations ti exceeded d d 50%%i in 1983. 8 D Dominance i of f foreign bonds against domestic bonds lasted until the early 1990s. 1990s Domestic bond market had to be deregulated in order to survive Internationalization necessitated deregulation of domestic market

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Domestic and Global financial system in high growth era of Japan: 1950 1950-1973 1973Heavily regulated Financial sector Fixed exchange regime

Lesson 3: Banking sector problem under the distorted financial liberalization Distortion in the process of financial deregulation in 1980s Financial liberalization deregulated financing options of (large) corporations in the beginning of 1980s. Deposit rates were decontrolled gradually during 1980s and 1990s from rates on large deposits and completely unrestricted by 1993

Domestic: Bankcentered system

Foreign capital control

Global: Bretton Woods system

Interventionism (Industrial policy, etc)

Effectiveness of fiscal policy

Banks’ strategy gy diversifying y g their activities were hampered by the remaining regulatory framework. Substantial disequilibrium between banks’ asset side and liability side Banks expanded real estate lending and SME loans.

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Disequilibrium between both sides of balance sheet in domestic banks in 1980sBank’s B/SLoan to good borrowers Manufacturing exporters Large firms in Keiretsu Loan to real estate industrySME loans related to real estate

Lesson 3: Banking sector problem under the distorted financial liberalization (2) Banks increased exposure to real estate by the search for new borrowers in the wake of the exodus of traditional customers to the bond market. When stock and land prices dropped in the early 1990s, the exposure came close to huge amount of bad loans. Through Th h the h early l 1990s, the h options i f for savers were very restricted. Japanese banks were the largest and least profitable in the world by the mid-1990s The same pattern of distorted liberalization precending a major fi

nancial crisis has been very common about many economies in the 1980s and 1990s.

Domestic Deposits

S b t ti l di Substantial discrepancy

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Lesson 4: Achievements of the Japan’s financial liberalization Japan’s Japan s‘Big Big Bang Bang’ from 1996 to 2001 was the process to complete financial liberalization in Japan. 1998 reform of the Foreign Exchange Control Act was revised. Financial Supervisory Agency were newly created and Prompt Corrective Action (PCA) introduced. introduced

Lesson 4: Achievements of the Japan’s financial liberalization (2) What did Japan achieve from the financial liberalization over 30 years? Yen became a fully convertible currency and is still the only currency in Asia that meets the full convertibility. Japan has a single financial supervisory authority to cover entire financial markets and institutions. institutions

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Impacts of Subprime Loan Crisis on Japanese financial sector Japanese economy under the recent Subprime Loan Crisis is viewed as an example to learn how the country with fully convertible currency, liberalized financial market, and high dependency to exports to crisis-hit advanced economies responded the world wide crisis. Japanese J banking b ki sector, t different diff t from f US and d European banks, did not suffer from direct holding of securities related to subprime loan in the US. US As a result, Japan’s banking sector had no substantial reduction of capital p ratio.

Impacts of Subprime Loan Crisis on Japanese financial sector (2) Steep decrease of export demand and rapid appreciation of yen especially after the Lehman failure in Sept. 2008 made substantial losses on Japanese major exporting companies. Large companies that were also hit by collapse of CP and b d issuance bond i markets k t j jumped d into i t bank b kl loan markets k t after Sept. 2008. Banks responded the steep increase of loan demand by large corporations while keeping loans to small enterprise p constant. No credit crunch were observed during the recent financial crisis.

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Amount of Domestic Bank Loans by Borrower Size%13.00

BIS Capital p Ratio of Japanese p BanksCity banks (average) Regional banks II (average) Regional banks I (average)

Amount of loans as of Sept. Sept 2006= 100 170.0 160.0 150.0 Loan to small firms (manufacturers) Loan to small firms (non-manufacturers) Loan to large firms (manufacturers) Loan to large firms (non-manufacturers)

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11.00140.0 130.0 120.0

10.00

9.00110.0

8.00 Data: All Bankers Association of Japan 7.00

100.0 90.0 80.09/2006 12/2006 3/2007 6/2007 9/2007 12/2007 3/2008 6/2008 9/2008 12/2008 3/2009 6/2009

March 2002

March 2003

March 2004

March 2005

March 2006

March 2007

March 2008

March 2009

Data: Bank of Japan

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Impacts of Subprime Loan Crisis on Japanese financial sector (3) Japanese banking sector did not play a role to amplify the real negative shock from the global crisis.

Maintaining soundness of domestic banking sector is very important for the country open to the global economy. Th Therefore, f a role l of f fi financial i l supervisory i authority is one of most crucial factors. This can be achieved even if the country with fully convertible currency and liberalized financial markets.

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