[Charles Jannuzi, can you 'deconstruct' for us?] [Far Eastern Economic Review] JAPAN'S ECONOMY A Blueprint For Recovery http://www.feer.com
IN ONE CORNER, you have Japanese Prime Minister Junichiro Koizumi, accompanied by the mop-haired economics professor who's now his economic tsar. In the other corner, you have the vast majority of Japan's conservative political establishment. Look out. This could get interesting. The coming weeks will be critical ones in Japan, weeks during which Koizumi's government will put forth new plans to get the country out of its 12-year economic and financial funk. Koizumi is riding on a sharp rebound in popularity he garnered with his historic visit to North Korea, which emboldened him in late September to vest Heizo Takenaka, an aggressively reform-minded political outsider, with more formal authority than any outsider has had in decades. On October 22, Takenaka was to unveil the outlines of a plan to start pushing banks to deal with their bad-loan problems--but the announcement was delayed at the last moment. Later this month, he'll likely also put forth a set of stimulus proposals to try and give the economy a much-needed jolt. It'll be targeted at the twin problems that have caused Japan's malaise to persist for so long: deflation and bad debts in the banking system. Japanese governments have been struggling for more than a decade, putting out dozens of stimulus, reflation and banking clean-up packages to little avail. While they've thrown hundreds of billions of dollars into vain attempts to stimulate the economy and fix the banks, Japanese prices have continued to fall, causing consumer confidence to decline and corporate profits to tumble, which in turn causes more bad loans to pile up. Throughout it all, the economy has simply continued its slow-motion swan dive. Is there any hope that this time is different? History, of course, argues for caution. But there's a solid chance that if Koizumi and Takenaka survive--and that's an "if"--Japan may be about to pull out the stops on a reflationary package that will pack some punch. Why? Takenaka, though wildly unpopular with much of the political establishment, has a good degree of credibility with reformers--and, importantly, with the Bank of Japan, or BOJ, whose cooperation is crucial in any effort to get prices and consumer demand growing again. If the central bank is convinced that Takenaka is on the same page as it is regarding aggressive banking reform, it may well try to help him out. Reflating the economy--that is, getting prices rising again--is key to everything Takenaka wants to do. Ideally Japan would grow by boosting domestic demand. But six years of falling prices have produced the following downward spiral: Declining prices encourage consumers to put off spending in the hope of getting better value in the future. Even when they do spend, they pay cheaper prices, so corporate profits fall. Companies respond by cutting costs--laying off workers and reducing bonuses--which in turn reduces overall demand, and thus growth. The only way to get people to spend is to reduce prices again. Keep that up, and you have a recipe for a crippling economic disaster. In the early years of Japan's slump, most banks' bad loans were to companies who'd gone overboard during the 1980s bubble with property boondoggles and other trophy projects that would never make a return. But now, there are hundreds of real companies whose businesses, which might be viable otherwise, have become untenable with prices and demand spiralling downwards. If the ultimate goal of a banking plan is to build sustainable banks as the foundation for the economy, there's no way it can happen without rekindling demand, because more bad loans will just pile up. And so here's why Takenaka's presence matters. Throughout Koizumi's time as prime minister, the BOJ and the government have often headed in different directions. BOJ Governor Masaru Hayami has held out for tough moves against the banks as the key for any policy to get Japan on its feet. Now, with a like-minded man in charge of banking policy, it's possible he'll pursue the sort of creative easing that a central bank needs if interest rates are already zero. In an October 15 television interview, Hayami hinted as much, saying in cryptic central banker-speak that though the BOJ can't cut interest rates any more, "there are still things we can do." Of course, there are still enormous hurdles in the way. Conservative factions in the Liberal Democratic Party, or LDP, the deeply divided ruling coalition whose members include both the prime minister and his most aggressive critics, are sniping about the "Koizumi-Takenaka shock," which helped send Japanese share prices to a series of 19-year lows following Takenaka's ascension. After Takenaka said in a magazine interview that no bank or company was too big to fail, corporate and banking chieftains scurried to sympathetic politicians for help. And they have helped: On October 17, the Development Bank of Japan, a government institution that uses taxpayers' money, chipped ¥10 billion ($80 million) into a ¥60 billion bailout of troubled retailer Daiei. Political infighting is the likeliest explanation for the banking plan's delay. Still, if a meeting of minds between Koizumi, Takenaka and Hayami has indeed been reached, it would have profound effects on the way the government proceeds. Koizumi, who has shied away from traditional construction-binge fiscal-stimulus packages, says he wants ¥1 trillion in tax cuts in the coming fiscal year, which begins April 1. And many expect to see a degree of experimentation out of the BOJ that economists will be studying for years to come. The central bank has already lowered nominal interest rates essentially to zero and pushed year-on-year growth of M1, the monetary aggregate it directly controls, to around 30% late last year--though the acceleration stopped this spring. In September, it puzzled markets by announcing it would buy equities from banks, a move which could help them clean up their balance sheets and which is as far from the central bankers' textbook as it comes. This may be only the beginning. Many call for the central bank to adopt, and stick to, an inflation target, which would force it to print money until prices start rising. That's unlikely, but even if the BOJ doesn't choose that option, it could buy more stocks, property, bad loans, government bonds or dollars. "There are lots of unconventional policies for the BOJ to adopt," says Masaaki Kanno, JPMorgan's chief economist in Tokyo, who worked at the central bank for over two decades. "The initiative to buy stocks from banks is the first of many that we will see in the future." Most figure these are worth a try. Buying government bonds would increase money supply and lower the only real interest rate that's still positive--that on government bonds. Buying dollars would also pump more yen into the economy. Many economists argue that buying assets would be more effective in boosting prices, and thus stimulating demand, than the BOJ's years of lowering interest rates, which has done little to encourage the country's moribund banks to lend more. Risky? Sure. Imagine, for instance, that it works. Kenneth Rogoff, an economic counsellor to the International Monetary Fund, says there's plenty of chance that inflation would overshoot, perhaps even to double-digit levels, if the central bank makes such a huge change in the way it does business. "People who think you can smoothly turn a dial and can go from minus 1% deflation to 2% inflation, people who think Japan can move in a very short period to a standard New Zealand-type inflation-targeting set-up, are very na.ve," he says. But the urgency is there. Earlier this year, when the economy was thought to be improving, there was widespread hope that deflation was being snuffed out. But such optimism has dimmed. The most visible example of this was the activities of the Japanese unit of McDonald's. It became a symbol of deflationary times a little over two years ago, when it halved the price of a regular hamburger to just ¥65 on certain days. In February, it raised the price to ¥80, apparently deciding diners would be prepared to spend more. But the price increase damped sales and McDonald's cut prices again earlier this month, offering burgers for just ¥59 each. That's the kind of spiral that has led to Japan's lost decade. Since 1992, Japan has grown at a real average of 0.9% annually--and a nominal average of just 0.5%. Assuming the long-term sustainable growth rate for an economy of its size is around 3%, the world has lost an economy the size of South Korea's, just because of forgone growth in Japan. Over the past 10 years, Rogoff notes, per-capita income in Japan has gone down by more than 10% relative to Europe and by much more than that relative to the United States. "Absent taking some action," he warns, "over the next 10 years you would see at least the same drop again." You can't tell that in Tokyo though. Throughout Japan's boom years, government officials talked of building the country into a "lifestyle superpower" to parallel its economic status. Now, in its dark economic days, pockets of lifestyle superpowerdom are emerging. Tokyo boasts bevies of new restaurants, luxury goods retailers and super-expensive skyscrapers. The Mitsubishi Group has completely transformed the neighbourhood in front of Tokyo Station, whose new buildings have changed it from a stodgy, boring place which businessmen fled in the evenings, into a trendy, cobblestoned neighbourhood filled with popular shops, restaurants and nightspots. Bulgari opened a new outlet in Ginza on October 10, and within a day had sold all of its stock of Ginza watches priced at ¥170,000 apiece. Meanwhile, a bottle of imported wine in Tokyo costs less than half what it does in Hong Kong. This makes it hard to convince authorities of the urgency. "When people say 'crisis' or sense of urgency, people tend to imagine the situation in Brazil or Argentina," says Hidehiko Nishiyama, director of the Americas division at the Ministry of Economy, Trade and Industry. "But Japan has a far deeper accumulation of wealth compared to those countries. Japan will not be a country to be helped by the IMF in the near future." Nishiyama claims he can get a better Italian meal in Tokyo than in New York. And without that sense of crisis, reformers have an uphill battle in pushing painful reforms. With the global economy sputtering, and world stockmarkets periodically threatening to go into meltdown, any banking plan that forces more bankruptcies and unemployment will be hard to implement. Politicians calling for a go-slow approach point to the stockmarket's malaise, mounting bankruptcies, and the 5.4% unemployment rate, which is near a record high. "The underlying conditions are about as bad as they could be for pursuing this sort of reform," says Frank Packer, an economist with Nikko Salomon Smith Barney in Tokyo. As an indication of the strength massed for a go-slow approach, the LDP faction led by Ryutaro Hashimoto, the former prime minister who was once thought to be Japan's next great reformer, put out a policy paper a week before Takenaka's outline. On banks, it called essentially for waiting until the economy gets better. The Hashimoto faction is the LDP's largest. TWO-LEGGED BEAST But while you can't fix the banks without reflating the economy, you similarly can't put the economy on a stable footing without fixing the banks. Bank lending is roughly equal to total economic output, so banks are the main funnel of cash to Japanese businesses and the funnel is jammed. As long as banks refuse to come to grips with their problems, they keep deadbeat corporate borrowers alive and healthier rivals can't get the funding they need to grow. This keeps millions of people and trillions of dollars locked up in the limbo of loan collateral and dries up new bank lending that might go to more productive uses. Consider how much potentially productive money is tied up in Daiei, the troubled retailer that operates supermarkets, many of them in declining neighbourhoods, plus eight restaurant chains, seven hotels and a baseball team. The company has some $17 billion in debt, and it survives on a lifeline from its three main lenders, Mizuho Holdings, UFJ and Sumitomo Mitsui Bank. In February, in a move that did much to convince people Koizumi wasn't serious about reform, they pumped ¥520 billion to keep Daiei afloat. In October, they pumped in another ¥60 billion, with help from the Development Bank of Japan, a government bank. Daiei's 29,000 employees can see that reform would be wrenching. Had the company been left to fail, most would have lost their jobs, and a plethora of small suppliers, many of whom rely solely on Daiei for their business, would have gone out of business. But at the same time, the bank funds that keep it on its lifeline could be used to clean bank balance sheets, and in the long run, be lent to more productive borrowers. The valuable land that Daiei holds--and there is plenty--could go to buyers who would use it better. It's hard, but it's the principle that's worked in nearly all successful banking-system reforms. So here's how to judge a banking plan. One key signal will be whether the government admits the severity of the problem and comes up with an estimate for the scale of bad loans that private-sector analysts won't find laughable. While analysts vary widely on just how much bad debt there is in the banking system, projections range from two to four times the official figure of ¥52 trillion. That's far more than Japanese banks could handle on their own if they were told to write off their losses right away--meaning the government would likely have to step in with trillions of yen in financial support. Such a bailout would put a strain on the public purse and be widely unpopular--key reasons it hasn't been attempted in Japan except in times of near-crisis. INADEQUATE CAPITAL Banks will also have to deal with questionable capital-adequacy norms. Current regulations allow Japanese banks much more room than is usual in the West to pad their capital with items that may disappear in the future--such as potential tax credits and securities that have to be redeemed. Standard & Poor's estimates that almost all the core capital of Japan's biggest banks is now such squishy stuff. Takenaka's team is already reportedly mulling a review of capital rules to make banks sounder, but such a step could end in the government having to pump even more money into bank support. And that's just the short-term stuff. Even if you wipe clean their balance sheets, there's no guarantee that the present management can make them into good banks. In the two weeks after Takenaka declared that no bank is too big to fail, the banking index on the Tokyo Stock Exchange crumbled 17%, with shares of all the large institutions--with the exception of Bank of Tokyo Mitsubishi, the healthiest of the big ones--falling precipitously. "The initial solution was to build these big banking groups," says Paul Migliorato, a senior analyst at Commerzbank Securities in Tokyo. "If you look at share prices, the market's telling you that you don't have four secure banking groups. You have maybe one or two." So which is the way forward? For now, Koizumi's popularity keeps him in power--the LDP can't dump the only member of the party who commands 70% approval ratings. But if his team starts seriously trying to take out vested interests, things might get nastier. After Koizumi named Takenaka to the financial-services post, party stalwarts screamed about how he wasn't playing by the traditional rules of horse-trading between factions. Takami Eto, an LDP veteran, compared the prime minister to Adolf Hitler. And so as he and Takenaka begin their treacherous tightrope act, perhaps the biggest concern is how long the government can hold all this together. "Getting out of deflation is like getting out of inflation," warns Peter Tasker, an influential strategist with Dresdner Kleinwort Wasserstein in Tokyo. "It's a multi-year issue, credibility is important, and you have to have everybody on board. It's got to be the policy priority."
