Japan's Financial Mess

Edward F Lincoln. Foreign Affairs. Volume 77, Issue 3. May/June 1998.

In Denial


Japan's economic performance in the 1990s continues to be disappointing, frustrating, and worrisome. Tokyo's economic sluggishness in the financial sector is souring life at home and setting off international reverberations. Much of Japan's financial weakness is mirrored in other Asian countries. More important, Japan's failure to deal with its economic woes provides a cautionary tale of the resistance to reform that should be expected elsewhere in the region.

Despite government and media portrayals of imminent "big bang" financial reforms, the reality will be far less dramatic. Among bureaucrats and politicians there remains a strong faith in the Japanese style of capitalism and a resistance to truly liberating financial markets. Nor is the Japanese public clamoring for deregulation. It associates such reform with unemployment and instability in personal lives. Indeed, the Japanese have spent the past half-century trying to reduce such uncertainty.

The problems of the 1990s were started by the bursting of the real estate and stock market bubbles of the 1980s. The government deserves much of the blame for the financial excesses and the stagnation that has followed. Dogmatically conservative attitudes toward macroeconomic policy are delaying recovery. The financial sector is swamped by a mind-boggling array of bad debts and underfunded pension liabilities, amounting to as much as $1.5 trillion. Scandal after scandal exposes unethical or illegal behavior in the financial sector and government. And many of the policies being adopted to clean up this mess will delay resolution of the bad debts and counterproductively increase government control over the financial sector.

Despite the torrent of pronouncements from Tokyo about economic stimulus and deregulation, the world will be disappointed with the results. While some financial deregulation will occur, those who believe that Japan will adopt an American economic model are mistaken. Japanese bureaucrats and politicians, including the elite at the Ministry of Finance, continue to be in deep denial. They do not comprehend the extent of reforms necessary to restore the nation to economic health. Instead they regard their current problems as a passing incident with no fundamental implications for the existing system.

These problems harbor a variety of international ramifications. The International Monetary Fund's bailout for Indonesia, Thailand, and South Korea includes substantial reform of their financial systems. Unfortunately, Japan will not be a firm supporter of this initiative. Nor will Japan import many more goods and services as Southeast Asia attempts to export its way out of trouble. Japan has damaged its selfassumed role as a leader of Asia and will prove a weak international partner for the United States.

A Creature of Habit


Japan's present economic problems and reluctance to reform itself is a matter of habit: from the late 1940s through the 1970s, the Japanese economy operated with highly regulated financial markets. The financial system intentionally favored intermediation through banks, and banking and securities firms were strictly separated. The government controlled virtually all deposit and lending interest rates, securities trading commissions, and the design and prices of insurance products. Furthermore, foreign exchange was tightly controlled (along with a fixed exchange rate until 1973 and a heavily managed floating rate for the rest of the 1970s) and the variety of financial instruments was subject to approval by the Ministry of Finance. Rather than manipulating interest rates, the central bank kept them below market clearing rates. Commercial banks were therefore dependent on central bank credit to allocate credit to industry.

The Japanese government strongly believed that private markets could not be trusted and therefore kept a firm hand on the economy. This approach heavily favored a flow of funds through the banking system while constraining the size and role of bond and stock markets. Banks were more easily controlled and permitted less public disclosure of corporate information than equity markets. In essence, regulation guaranteed high profits for financial institutions, in exchange for which it behooved those institutions to heed guidance and suggestions from the government. This financial system performed well in the high-growth years of the 1960s. It is easy to understand the nostalgia that leads the Japanese to want to keep it alive.

Bursting the Bubble


Japan's era of roughly lo percent annual growth ended in 1973, after which the economy grew at a more modest 4 percent until the early 1990s. The Japanese slowdown has brought a gradual, piecemeal unraveling of the postwar financial sector. Slower economic growth also reduced demand for loans to finance plant and equipment investments by large manufacturers. Eager for new business, large commercial banks moved into real estate lending in the 1980s with the Ministry of Finance's explicit support and guidance. Along with insurance companies and securities firms, they invested aggressively overseas as regulatory restrictions fell. For the first time in decades, the banks were faced with unfamiliar loan clients, but they continued to assume that the Ministry of Finance would guarantee their viability. Their recklessness fed the real estate and stock market speculation of the late 1980s, which caused both urban real estate and stock prices nearly to triple in four years.

Furthermore, Japanese financial institutions' penchant for making investments based on long-term personal or corporate relationships had serious repercussions, especially when banks sought new clients. Banks began financing new borrowers with the same assumption that personal relationships would suffice as a screening mechanism. The herd instincts of Japanese banks took the place of hard-nosed financial analysis.

This explanation, however, puts the most charitable face on what was happening behind the scenes in Japan in the 1980s. The scandals that have emerged in the 1990s have revealed shocking examples of indiscretion and malfeasance. Favored investors at securities firms were given guaranteed returns on their equity portfolios. Huge loans went to small businesses for speculation in the stock market and real estate. Large banks eagerly introduced crooked clients to subsidiary banks or credit co-ops in order to keep questionable loans off their own books while hoping to benefit from the business. Financial institutions continued to pay off racketeers who threatened to reveal negative information at annual shareholder meetings. Ministry of Finance officials told banks when inspections would occur in exchange for lavish entertainment and other favors. And there have been allegations that the Ministry of Finance approved and recommended illegal schemes to hide financial problems.

These scandals go far beyond isolated incidents. They suggest a debilitating fear of disclosing bad news, illegal dealings between financial institutions, politicians, and bureaucrats, and the involvement of organized crime. Presumably much of this behavior took place before, but both the need for new outlets for lending and the euphoria created by the stock and real estate bubbles drastically increased its prevalence.

When the bubbles burst, the fallout included enormous bad debts, the magnitude of which is still not known, mainly because of Japan's loose requirements on reporting nonperforming loans. In late 1997, the Ministry of Finance admitted that problem loans totaled some 79 trillion yen ($630 billion), about 15 percent of all Japanese bank lending and an enormous 16 percent of GDP. These levels of bad debt resemble those in Indonesia or Thailand.

More bad news may be coming since Japanese banks hold roughly one-third of international loans to South Korea, Thailand, and Indonesia. Officially, Japanese lending to Asian countries totals some $125 billion, but it may be larger. An unknown portion of these loans is nonperforming, but if Japanese banks behaved with the same imprudence as elsewhere, the prognosis is not good. Moreover, the banks are already weakened and are not in a good position to absorb additional losses.

Survival of the Weakest


Restoring Japan's economic growth will be critical to any effort to overcome its financial problems. In a growing economy, new lending causes the share of old nonperforming loans to shrink, reducing the relative cost to financial institutions as they write them off and dispose of the underlying assets. The government's record, however, is not encouraging.

From 1992 through 1995 Japan grew at an average annual rate of only o.6 percent. In 1996 the economy finally showed signs of recovery, growing at a strong 3.6 percent driven in part by expansionary fiscal policy, including a temporary income tax cut in 1994. But on April 1, 1997, the dogmatic Ministry of Finance chose to end the income tax cut, increase the nation-wide sales tax from 3 percent to 5 percent, and raise other government fees, including copayments in the national health care system. These changes subtracted 2.5 percent from GDP and may have had an additional negative psychological effect on households and businesses. The economy was relatively stagnant again in 1997, and forecasts for 1998 are in the range of one percent or less. Responding to criticism, the government finally devised an income tax cut for fiscal 1997 (payable only in February and March of 1998). But the size of this stimulus was small, and the government followed it with statements that it would contemplate no further tax measures.

Tokyo's reluctance to use fiscal policy to stimulate the economy stems from the fact that the government's balance sheet will deteriorate as Japan's aging population collects its social security. Nevertheless, the government moved too rapidly and too far to balance its budget in the spring of 1997. Restoring economic growth is as important a goal as a long-term reduction of the government's deficit. Domestic financial problems would diminish in a growing economy, and the burden of financing the retirement of a larger percentage of the population would become easier too. Japan's dogged determination to pursue fiscal austerity will hurt the future of the economy by delaying recovery.

Japan's apparent failure to get its economy back on track has not led to a market-oriented approach of letting the weak collapse, forcing investors to take their losses and sell off assets at market prices to get them back into productive use. Only such an approach can address the fundamental problems that led to the crisis. In 1997, the Ministry of Finance allowed two large institutions to fail-Yamaichi Securities and Hokkaido Takushoku Bank. But press reports that market rules were now in play and financial institutions would have to sink or swim proved premature. The shutdown of Yamaichi Securities took more than six months, with most of the employees kept on the payroll-financed with loans from the Bank of Japan. During those six months, the Ministry of Finance continued to seek firms to take over all or substantial portions of Yamaichi. (Merrill Lynch, for example, is taking over some Yamaichi local offices and employees.) Similar efforts with Hokkaido Takushoku Bank proved successful: Hokuyo Bank, a regional bank in Hokkaido, agreed in December 1997 to acquire all of Hokkaido Takushoku's operations within the prefecture, and Chuo Bank agreed in February 1998 to acquire all of the bank's operations outside of Hokkaido. This deal was sweetened with promises, since enacted into legislation, that the government would buy preferred shares and absorb bad loans. This is hardly the stuff of a cruel and impartial market. Few people will be left unemployed, and few if any assets will be sent to the auction block.

Worse yet, this bailout scheme has now become policy, with the government moving forward in March 1998 with a $100 billion purchase of new issues of preferred shares and subordinated bonds to help recapitalizing banks. Putting government money into bank ownership is a terrible policy. It encourages banks to gamble on high-risk investments to increase their earnings. It also makes the government even less willing to let weak institutions fail because the government's money and reputation will be at risk. Perhaps most important, this infusion will increase Ministry of Finance influence over the whole banking sector since a number of presumably strong banks will issue equity to the government on the excuse of preventing the public from knowing which institutions are weak.

Besides this special new fund, the Japanese government has other means to inject money into the corporate sector without public knowledge. Portions of social security funds, postal savings funds, and postal life insurance funds are routed through government subsidiary organizations, which have a mandate to offer portfolio investments in the private sector. These funds can be quietly invested in weak financial institutions or used to help prop up overall stock market prices without the media or public becoming the wiser.

Meanwhile, a variety of other gimmicks appeared in 1998 to improve balance sheets and thereby prevent public recognition of weakness or insolvency. Firms have traditionally listed assets at the price paid for them, which has long injected an element of fantasy into accounting results. Financial institutions will now revalue real estate holdings (mainly the land on which their offices and branches sit) to market value, but they do not have to do the same with stock portfolios, many of which hold shares purchased near the peak of the stock market. Banks will also be able to net out positions with individual customers; rather than showing a single client's loans on the asset side of the books and deposits on the liability side, the asset side will show only the net position. This sleight of hand artificially reduces assets, thereby improving the bank's capital-to-asset ratio. The government has even discussed using public funds to buy real estate to prop up prices.

One can hardly imagine a litany of worse practices to deal with the financial problems in Japan. These policies will prolong the debt problem, artificially support weak financial institutions that are a drag on the economy, and yield a financial sector partially owned by the government. Gimmicks and government capital infusions will probably stave off a serious financial collapse, but at the expense of the economy's long-term health.

Japan's Wish List


In the midst of dealing with its debt problems, Japan is presumably engaged in a sweeping deregulation of financial markets. The agenda for deregulation includes a variety of measures affecting virtually all aspects of finance, to be completed by 200. The primary changes under consideration include further deregulating foreign exchange, decontrolling brokerage commissions, easing the trading of shares outside the exchange, relaxing rules concerning the over-the-counter market, eliminating the securities transaction tax, legalizing financial holding companies, permitting asset-backed securities, easing restrictions on derivatives, deregulating the insurance sector (permitting price competition, allowing greater flexibility in product design, and removing the strict separation of life and non-life insurance companies), lowering the barriers separating banking and securities, and ending the segmentation among different kinds of banks. Deregulation of foreign exchange transactions, removal of the holding company ban, and decontrol of brokerage commissions will all begin in 1998, with other reforms following over the next three years. On the surface, the list of proposed changes is ambitious and would seem to drive Japan toward greater reliance on markets and competition. But will it really happen? There are reasons to be skeptical.

First, Tokyo's bailout of the financial sector speaks volumes about the government's true attitude. No matter what the image of the "big bang" reforms, resistance to liberating financial markets persists. Over the past 20 years, the Ministry of Finance has endorsed a gradual deregulation process, but it shows few signs of truly embracing American-style finance. Second, Prime Minister Ryutaro Hashimoto and the Liberal Democratic Party have an overriding interest in restoring their numerical majority in the Diet, for which they seem to believe that the appearance of reform is sufficient. Third, a deregulated financial system requires public disclosure of corporate information as well as controls on insider information. Japanese corporations are infamous for concealing their numbers. Corporate annual reports in Japan convey little useful information, and official financial filings are hardly better. Almost nothing is happening to address this problem, which is woven into the fabric of Japanese society and corporate behavior.

Wanted: A Global Partner


Overall, Japan's situation is not encouraging. An outright financial collapse with many banks going belly-up is unlikely, if only because of the lengths to which the government will go to prevent it. But the more likely scenario-Japan muddling along with substandard growth and an unstable financial sector-is hardly more encouraging. Neither scenario is good for Japan, Asia, or the world.

Japan's financial straits do not bode well for the International Monetary Fund, especially as it attempts to reform the financial doings of Indonesia, Thailand, and South Korea. Despite the seriousness of Japan's financial troubles, neither Tokyo nor the public believes in the American economic model. Japan's reluctance to undertake reform implies that its officials will provide only lukewarm support for the IMF and may send conflicting signals to other Asian nations as the crisis moves into its next stage. This is all the more unfortunate since Japan is a leading member of the IMF.

Furthermore, Japan's economic stagnation suggests that it will do little to revive Asia's health. Asia's struggling economies will try to recover by increasing their exports. As the world's second-largest economy, Japan could play a helpful role by absorbing a portion of those exports. But here is the rub: Japan is following the same strategy as its poorer Southeast Asian neighbors. Rather than absorbing more imports, Japan will shift its burden through more exports to the United States. Despite any rhetoric about a global partnership, Tokyo is quite willing to let the United States underwrite the Asian recovery.

The international ramifications of Japan's financial weakness extend beyond economics. The Japanese are now absorbed by domestic problems; they have little interest in the problems of the rest of Asia. Japan was noticeably silent during the recent crisis over Iraq, articulating only the request that any military action be postponed until after the Nagano Winter Olympics. In the midst of South Korea's economic crisis, Japan chose to press a petty dispute over fishing rights. Just a few years ago, Japan was awash in talk of playing a larger role in the world, and the government mounted a modest campaign to become a permanent member of the United Nations Security Council. Today there is little interest expressed in international diplomacy.

The United States must make its dissatisfaction with Japan known. Tokyo's response to the Treasury Department's complaints during the past year gives little reason for optimism. Nevertheless, this pressure should continue. American economic policy should also assume that Japan's economy and financial system will perform poorly for several years to come, implying lower export growth and rising imports for the U.S. economy.

Washington has found it difficult to exert pressure on Tokyo. It is time for the United States to send less-than-subtle signals in other areas of its relationship with Japan. The bilateral relationship includes broad consultative arrangements, within which American officials could simply stop consulting. Through canceled meetings, unreturned telephone calls, and a lack of advance notice of American policy moves, the United States can send the message that it no longer regards Japan as a global partner. This may seem like a heavy-handed way to treat the world's second-largest economy, but under present circumstances it may be the only way to move Japan off a path that is destructive for us all.