Bund Summit:
Thank you very much for joining us today, Mr. Nakao. This interview is going to focus on the Japanese economy; we will also touch on the world economy (including the Chinese economy) and global governance, which is your field of expertise.
Let's start with the Japanese economy. Taking a look back, what do you think were the background information or judgment of the Bank of Japan (BOJ) that led it to deliver a rate hike in July?
Mr. Nakao:
The basic idea is that the BOJ must normalize its monetary policy.
Previously, it had long implemented unconventional policies to support getting out of the deflation spiral, including zero interest rate, yield curve control, massive quantitative easing, forward guidance and a few other tools such as the purchase of ETF which is a stock, and REIT which is a real estate. As a result, there is a piling up of the asset of the BOJ. But it's not the normal way of managing the monetary policy. The central bank is supposed to look at the short-term interest rate, but not control the long-term interest rate, which should be decided by the market.
Considering the fact Japan has come to the end of deflation, with inflation at around 3% or 3.5%, and the normalized economic situation after the Covid-19, the BOJ decided that it was time to change policy and exit the unconventional policies gradually. That's how they’ve been trying to change course from the end of last year, and the July decision was based on that idea.
So, the BOJ stopped yield curve control, adjusted the short-term interest rate and decreased the purchase of government bonds, so that the accumulated balance sheet asset of government bond will decline, which is monetary tightening.
There was also other background information in addition to the rising inflation: Yen was becoming too weak, hitting over 160 against the USD, and it made people feel they became poor.
Yen is not regarded as a target of monetary policy, the depreciation of yen has a direct impact on people's sentiment and behavior and then affects price which is a target of monetary policy through the imported prices.
When I was a Vice Minister of Finance for Foreign Affairs, I intervened in the exchange rate in August and in the end of October-the beginning of November, buying in total $170 billion at the rate of about 79 yen per dollar on average in 2011. Back at that time, yen was very strong, or too strong, but this time it is too weak.
If we compare the prices of the United States and Japan, Japan’s inflation rate is always much lower than that of the United States. If we compare 90 or 160 yen per dollar, yen is very weak at 160. But if we also consider inflation differences, Japanese yen become even cheaper in real terms. That is also part of the information that the BOJ thought it should address.
Bund Summit:
That's a very detailed analysis. So, in your view, those are sufficient to justify this decision.
Mr. Nakao:
Yes.
Bund Summit:
How do you evaluate the Japanese inflation situation at the moment? Do you think inflation is going to fall at a faster pace than the BOJ’s expectation?
Mr. Nakao:
I don't know, because it depends on the commodity prices and the yen’s rate. If yen depreciates further, of course it would make the prices go high.
Now, we are in the exchange rate adjustment process. Yen has come down from 160 to around 140. It means that the price pressures from imported prices have come down, and so there is a possibility that inflation rate is becoming a bit more stable, and maybe there isn't this need of increasing interest rate.
But at the same time, regardless of whether we have high inflation or not, we need a certain interest rate to have disciplines in the market and disciplines for fiscal policies. I think the BOJ, to some extent, thinks a similar way. If there is a possibility of going back to deflation again, the policymakers would change their mind; otherwise, there's a possibility that they will continue to gradually increase interest rate.
Bund Summit:
The July hike together with the employment rate figures from the U.S. has triggered a major global market turmoil in August. Do you think this episode could reoccur in the future? And what are the challenges facing the BOJ in pressing ahead with its monetary normalization?
Mr. Nakao:
It's a very difficult question. If I were the executive of BOJ, I should be worried. But generally speaking, there are always adjustments for some reasons in the financial, stock and other markets. If we worry too much about certain volatility in the market, we cannot change any policy.
The stock prices in Japan were, in a sense, elevated, because of yen depreciation. Nikkei and other indexes are often based on bigger companies, and big companies tend to export more. They have more assets abroad, whether it is investment in facilities or financial investment. They would gain if yen is depreciated, and their stock prices would go up.
Of course, Japanese companies are now making a lot of money. They retain more of their income, instead of paying for wages, so they are more profitable today. This, in addition to the element of yen’s depreciation, has resulted in the peaking of the stock prices.
So, stock adjustment was possible anyway, and the adjustment turned out to be very quick because of the algorithm transaction and other factors. But we don't need to overreact to these. Market is always volatile, and it has been more volatile because of algorithm transaction and the investment ideas.
So, even if I said if I were the executive of BOJ I should be worried, but this can happen, and we don't need to overreact to it. Sometimes, certain information can trigger big adjustment, but the market can be adjusted the other way again later.
Bund Summit:
The Fed is going to deliver rate cut and that's almost baked in September. Against this backdrop, how much room does the BOJ have to continue to raise its interest rate? How do you evaluate the level of impact of rate hikes on Japan’s economic momentum? If the rate hike suppresses the contribution of export to the Japanese economy because of the yen movement, do you think domestic demand is sufficient in supporting Japan’s economic recovery?
Mr. Nakao:
My remark is not based on detailed information about BOJ decision making. But generally, if the interest rate reductions by the Fed is very quick, it can give some change of ideas to the BOJ, or at least affect the pace.
But as I said, the idea is that we should normalize monetary policy, and even if the Fed lower the interest rates, the Japanese interest rate is still much lower compared to that of the United States. The BOJ is trying to, once again, normalize the policies in terms of the purchase of government bond and especially the short-term interest rate, but I don't know exactly the speed and to what extent.
Today, yen’s exchange rate depreciation doesn't really invite the increase of export as much as before, because Japanese companies have many facilities abroad. Besides, cheap yen has a negative impact on households. The imported price is one channel, but if yen becomes weak, it also means that the Japanese people feel that they become poorer by the international standard, and that they spend less on consumption and investment. It is a kind of negative “wealth effect”. The people who used to go to Hawaii or Shanghai or Europe would decide not to go because it's too expensive.
So, the yen's some strengthening can secure people’s feeling. The Japanese people feel that they became poor because of yen depreciation and they are more concerned about the future of the Japanese economy. Then if yen is coming back, they may think there are not much serious issues about the sustainability of the Japanese economy.
Another post-development is from interest rate adjustment, as rate hikes increase the interest income for the households. Households are generally creditors and governments are debtors. Government borrowed a lot from households and other economic sectors. Hence, as the interest rate goes up, borrowers such as home buyers would feel increased burden, but pensioners and other savers can gain. It boosts people’s sentiment.
Talking back to the exchange rate. Yen movement is as important information for the consumers as well as for business communities. The business communities often buy companies from abroad. If the yen is cheaper, it means that buying a foreign company becomes very expensive, and foreign companies can easily acquire Japanese companies.
When it comes to yen depreciation, there are too many talks about export competitiveness, but yen is also important for consumers and for companies who try to acquire their counterparts in other countries. So, yen should be relatively strong and stable, instead of becoming very weak.
Bund Summit:
Let's talk a little bit about politics, because of Mr. Kishida’s recent decision not to run for the next LDP leadership or the next prime minister, which means there's going to be a new administration. Do you think that will introduce new uncertainties into the Japanese economy, and what kind of new uncertainties or risks? What are the most pressing economic or social issues for the new administration to tackle?
Mr. Nakao:
There are political changes based on the elections, and we cannot totally secure the certainty by having the same people forever. So, we should respect the decisions of Mr. Kishida to step down. There can be uncertainty, but this is a normal phenomenon.
I don't think there is going to be much change to the policies by the next administration. On policies regarding defense, childcare, how to use their budget in some areas and others, there can be some difference, but not totally different.
One of my hopes for the new leadership is that, it's better to have more engagement and discussion between China and Japan. In comparison, the U.S. government has sent many minister-level officials including Blinken, Yellen and many others to China, but Japan didn't have such talks with senior Chinese officials.
This Bund Summit is contributing to discussions between people. I hope we resume more frank and frequent dialogues and exchange of views between the Chinese and Japanese senior officials despite some of the differences of our ideas.
Second, there will be elections in the U.S., and whether it is Trump or Harris that takes office, Japan is an important ally of the U.S. and influenced by the policy of the U.S., so it's very important to have a good relation with the new U.S. administration. That’s another thing I expect the new leadership to do.
Third, the new leadership needs to look at the sustainability of fiscal conditions even more seriously. Japanese public debt-to-GDP ratio is now about 260%, by far the largest among major economies including the U.S., China and others.
If that continues or it keeps increasing because of continuous fiscal stimulus, we may face difficulties of a very rapid hike of interest rate all of a sudden as people start selling government bonds. If someone wants the BOJ to purchase the government bonds to support the bond market, it might invite the sharp depreciation of yen, because people would start worrying about the Japanese economy itself.
We cannot continue to have this fiscal condition or even an increasing level of debt-to-GDP ratio. We should take care of it. It’s important to better manage fiscal expenditure, and think about how to make efficient use of the budget to support social security and welfare programs in medicine, aged care and other areas. We cannot avoid thinking about the possibility of raising tax revenue if it is necessary. I hope that the new leadership would think about the importance of sustainability of fiscal policies, even more than it does today.
Bund Summit:
That is a very important suggestion. Except for that, are there any other challenges for the new administration?
Mr. Nakao:
The long-term challenge is an aging and declining population.
Today, Japan's population over 65 years old already accounts for 29.3%. I don’t know the exact percentage for China, but it’s much lower at this moment. This percentage is much lower than Japan in many other countries, but they are also facing the same challenge.
The policies to reverse the course is now being considered. The Kishida government is always saying this. We can do it, but I don't think we can totally recover the fertility rate or the population replacement rate of 2.1. In Japan, this rate is around 1.4; China has a very low rate these days; and South Korea had 0.7 or so, partly because of Covid. This is a phenomenon shared by many countries, including European countries.
One of the reasons is that for women, marriage and birth is just not the thing to do, but more of a value-based choice. We can’t easily change it, even if we continue with the government funding and so on.
But this has a very large impact on the economy, because low fertility rate means that we always have more senior than younger people, and that means the ratio of the productive-age population is decreasing, which is “demographic onus”. The total population is shrinking, but at the same time we always have a larger population of seniors compared to younger population. The age structure of reverse triangle is still similar.
Instead of sticking to the idea of reversing it drastically, we should face the reality of declining aging population. We should look at policies of many kinds, including education, medicine, pension, infrastructure and urban development, based on the idea that we are facing secular population decline and aging.
I don't think human will disappear: there can be some time that people start to have more babies. But for some time—I don't know whether it is 30, 100 or 200 years—we'll face this phenomenon, so we should adjust to this reality.
Bund Summit:
Expanding a bit from that, China is now facing low inflation, low birth rate, and some of the other problems, including structural ones. That is very reminiscent of the Japanese experience. So, what suggestions do you have for Chinese policymakers?
Mr. Nakao:
The similar part of China and Japan in the 1990s is that there could be a real estate bubble burst.
In China, it would have a very negative impact on the demand side, with people saving more and consuming less; there is impact on the real estate developers, because they cannot sell the houses; banks who are lending to the developers and the purchasers of the houses may not be able to recover their loans; and local authorities also took a hit because they no longer enjoyed the proceedings from land sales or use right as much as before.
These are some similarities in China and Japan. To address these issues is very important, but it seems to me that it's not a good idea to continue to have a stimulus by larger infrastructure investment as China already overinvests in the infrastructure such as railways and roads, for instance. We should face up to the challenge of insufficient demand and try to promote consumption instead of investment.
The consumption of China is not as strong as in other countries, which is also related to the welfare and other systems. China should look at how to have a stronger redistribution system to close the divide and to promote the consumption of the middle-income group, or the middle class, and help poorer people become middle-income consumers.
At the same time, it's very important not to have a deflationary spiral. For that purpose, monetary policy and fiscal policy can be more expansionary. How to use the fiscal expenditure is important. If it is just used to invest in the infrastructure as before, it's not so efficient. It’s important to have a permanent system of supporting middle class to consume, to make poor people a part of the middle class, and avoid social divide.
I also want to mention the difference between China and Japan after the bubble bust.
The strength of China is that it is now very innovative, with many PhD holders in science and engineering and well-trained people, and entrepreneurship is much stronger in China. As China has a bigger population, it has more PhDs and inventors in absolute number. So it can win the international competition like in the Olympic games.
But at the same time, there is some concerning elements such as stricter government regulations for many reasons. Government regulations are needed in many areas, but we should also learn from the experiences of China’s development after opening up and reform.
The miraculous growth of China after opening up and reform has been essentially based on the market and the vigor of a private sector, as well as the engagement with other countries.
Japan in a sense lost some vigor or entrepreneurship after the bustle of the bubble. We are now trying to regain it. I hope that China continues to have a dynamic element of the market economy.
Bund Summit:
Having led the Asian Development Bank for many years, you know the best how these multilateral institutions work and run. How do you feel about the phenomenon that the multilateral institutions’ seemingly diminishing say, or power to influence decisions, in global governance? How can we enhance their role?
Mr. Nakao:
In a sense, this change is the thing to be expected.
The World Bank, the International Monetary Fund (IMF), and other financial institutions such as the Asian Development Bank (ADB) were more influential in the past, because there were more developing countries, and developing countries needed more money.
For example, just after the reform and opening up in 1978, China was very poor and very dependent on external resources, so ADB was more influential when China became its member in 1986; similarly, Japanese official development assistance (ODA) and foreign direct Investment (FDI) to China played a very important role in driving China’s development, and that added to Japan’s influence.
In the past, after World War II, the U.S. and European countries were so dominant in the global governance system, and Japan wanted to join it. But today, China and other developing countries have also increased their presence. They have more power and don't need to be influenced by the international organizations.
With this kind of backdrop, we are now having a reform in the international system, with many new multilateral institutions such as the Asian Infrastructure Investment Bank (AIIB) established. I have a very good cooperation with Mr. Jin Liqun; AIIB and ADB have many co-financing projects.
And also, the Group of 20 (G20) was created from the initial G7. Many important positions at the World Bank, ADB and IMF are taken by the Chinese. Of course, there is still the feeling that the Chinese are underrepresented, but in a way, they are well-regarded, and the influence of China is much greater than that of Japan in the 1970s-80s.
So generally speaking, when developing countries were poorer, they had no choice but to be influenced by international organizations. But now, these international institutions may be less influential, because of the stronger voices of developing countries, and coordination becomes more difficult in a way.
So, I wouldn't say that the international organizations become just weak, but the members of those institutions are different now, in a sense in a positive way. But at the same time, we must always be reminded that all players must make every effort to have utmost coordination through the international organization including the World Trade Organization (WTO) or the IMF.
I hope that in addition to traditional donors and supporters of these institutions like America, Europe and Japan, China and others should also play ever-more important roles of managing these institutions, and I think this process is unfolding.
We should further strengthen the role of international organizations. In this regard, the United States should be responsible. For example, the dispute mechanism of the WTO is not functioning well because of the lack of American support.
In conclusion, we should pay more attention to the work of international organizations to ensure they are more influential, and cooperate to that end.
Bund Summit:
How do you think the U.S. election will impact the Asian economy and the world trade and economy at large?
Mr. Nakao:
When Biden came after Trump, his trade policies didn't change much. It was more predictable, but the Biden administration didn't lower the tariff, for instance, to Chinese products. Likewise, I don't think there is a dramatic difference between Harris and Trump, but Trump is more unpredictable.
I don't think either of them would reduce the deficit of the federal government, because both of them have ideas more about how to use fiscal money than about how to finance expenditures. So maybe there is not so much difference regarding economic policy.
There can be a change regarding foreign policy, but I don’t know whether Trump or Harris would be tougher to China.
Bund Summit:
How do you feel about the Bund Summit?
Mr. Nakao:
We should keep in mind that the world community, including Asia, have had a very good development over the years because of the exchange of trade, technologies and peoples between countries. If we have a block among countries, it would damage such a development and even destabilize the global peace. We should remember that it was the fragmentation of the world economy and the protectionist policies by major countries that led to the outbreak of the World War II. We need a system of exchange of trade, goods, services, finance, investment, peoples, ideas and technologies. This would support common development as well as friendship and cooperation between countries.
Everyone agreed in this forum that we need exchange of views between countries, even if we have some different idea, and the Summit contributes to this very much, with many important people coming from different places of the world. I would like to express my strong sense of appreciation and gratitude for the Bund Summit and its staff to make this happen.
