International Perspective - by Marshall Auerback

JAPAN’S LATEST SET OF REFORMS: BE GRATEFUL FOR TOKYO’S TIMIDITY

10 April 2001

By Marshall Auerback

Another week, and another promise by the Japanese authorities to deal with their banking problems once and for all. Last Friday’s announcement, in which the pre-publicity hype again unduly inflated expectations, disappointed market participants, who seem increasingly frustrated by Tokyo’s apparent timidity in dealing with the bad loan problem once and for all. There is of course a parallel in the United States, where we are seeing increasing pleas for America’s Federal Reserve and the government to move further toward aggressive monetary and fiscal ease respectively. In the words of PIMCO’s managing director, Paul McCulley, "explicitly targeting at reducing rentiers’ real return on money balances to zero is one means towards that end. The Fed should simply do it, with dispatch. An even better means to a desirable Robin Hood outcome would be an aggressive reduction in taxes targeted at the financially weakest amongst us, not the strongest" in order to boost stronger aggregate demand.

But perhaps the markets should be careful what they wish for. Never has there been a period in which the policy requirements of Japan and America have been so fundamentally at variance. A full write-down of all bad debts in the Japanese banking system in the absence of a more aggressive policy of monetary reflation poses exceptional deflationary risks, hardly an auspicious time for yet another Japanese induced growth shock given the dramatic slowing of the US economy over the past 4 months. On the other hand, if Japan’s monetary authorities ever do fully grasp the nettle and move toward a deliberate policy of debt confiscating inflation, an inevitable by-product of such a policy will be a significantly weaker yen, with all of the attendant problems that this implies for America’s record current account deficit.

A correlative of a weaker yen is a stronger dollar. But every day US corporations now report earnings disappointments. Owing to a strong dollar, they suffer profit margin pressures. Owing to a strong dollar, they suffer eroding domestic and foreign sales, which is being reflected in a record current account deficit. Moreover, in the present instance the most recent outflow of short-term capital from the emerging world into the US (which has pushed the dollar index up to a 15-year high in recent weeks) has created financial and economic crises in these economies which further weaken global markets for US industries. Overall, the strength in the dollar exchange rate is now so great that US corporate profit performance is deteriorating and is falling short of expectations. This is one factor which explains why the US stock market has been floundering, with much of the weakness focused on corporations exposed to the adverse direct and indirect consequences of the dollar's strength.

On the other hand, suppose the Federal Reserve were to accommodate Mr. McCulley’s desire to move rates toward zero. Would this not pose risks to the external value of the dollar and thereby undermine Japan’s own attempts at reflation? Furthermore, what might happen were Messrs. Greenspan and O’Neill to move toward coordinated intervention against the dollar and try to "manage expectations" by "talking down the dollar". If dollar weakness were to go too far, it might encourage the cumulative speculative capital flows of the last several years to turn tail and run. In the words of former Treasury Secretary Robert Rubin, such dollar weakness could "drive investors out of American stocks, bonds and treasury debt." Indeed, a rapidly declining dollar would hardly constitute the most appealing environment for the Japanese to recycle their ex ante savings surpluses back into the US given that persistent dollar weakness would put such investments in the red in yen terms. And isn’t the whole rationale behind shifting Japan’s surplus savings abroad to engender a rate of return for the country’s ageing population above and beyond what can be achieved in a domestic context of paltry local returns by virtue of that very savings surplus?

It is this fundamental incompatibility of objectives that might go some ways toward explaining the policy incrementalism on the part of both American and Japanese policy makers at this juncture. We also believe this explains the conspicuous silence of the Bush administration in response to Japan’s latest banking package (then again, the Bush people may well have determined that current difficulties with China make this an unpropitious time to antagonise the Japanese as well). This is not to write Japan off completely in the interim, as many disappointed Western market observers appear to be doing today. Taken in aggregate over the past 10 years, what we continue to see in Tokyo is halting, intermittent progress—which is what we saw last week in spades and what we’re in for a great deal more of. This will probably remain true no matter who the Liberal Democrats find to replace Prime Minister Mori (who officially announced his resignation at the same time the new package was introduced), and no matter whether the LDP is eventually replaced by an energetic coalition of opposition parties with fresh ideas. And given the current global economic backdrop, perhaps such an incremental approach is the most realistic thing to hope for right now, notwithstanding the wishes of the west’s gung-ho reformers to the contrary. Ultimately, we expect that it will take significant crises of great magnitude in both the United States and Japan before the last vestiges of current central banking orthodoxy are finally overthrown once and for all. At that stage we expect to hear no further talk about the sustainability of putative accounting imbalances, the virtues of disinflation and prudent fiscal policy, as we envisage both countries will begin to proceed in a panicked way toward a mad dash for growth at whatever cost. This might also ultimately entail a large government role in the management of both countries’ respective banking systems, given the anticipated scale of the problem. But we are not at that stage yet; consequently, we expect policy to remain reactive and halting in both Japan and the US, inevitably accompanied by much bellyaching on the part of frustrated market participants, pining for a return to the good old days of constructive policy co-ordination (i.e., a regular supply of cheap Japanese capital to perpetuate Wall Street’s bull market).

Against this backdrop, let us consider Japan’s latest set of banking proposals in more detail. The core feature of the new banking reform is a plan to force debt-burdened banks to write off existing at-risk loans within two years. It is also important to note that this reform only extends to the country’s major banks and deliberately excludes the second-tier and regional banks (which, coincidentally, happen to be the leading lenders to the LDP’s core constituencies). This is the third such effort to rescue Japan’s banks since a similar crisis in 1998. Other measures include a bit of urban renewal spending and a pledge to increase unemployment benefits for workers laid off as a result of the bankruptcies caused by the bank bailout and the probable use of government money to facilitate the creation of a stock-buying body will be set to reduce major banks' cross-shareholdings and thereby minimise potential selling pressure within the equity market itself (here, however, details remain scarce). The package follows by a few weeks a Bank of Japan decision to revive its zero interest rate policy coupled with an apparent move in the direction of quantitative easing and direct inflation targeting.

There was much hope that, following last month’s announcement by the Bank of Japan to move toward quantitative easing in monetary policy and explicit inflation targeting, the country’s monetary authorities were at last coming to terms with the scale of the deflationary problem still evident after 10 years of economic stagnation. But there was a quid pro quo explicitly given at the time the new policy objective was announced: the BOJ argued that such aggressive reflation would prove ineffective in the absence of a genuine effort to restructure Japan’s bad debt problem once and for all. Within days, of course, the governor of the Bank of Japan was making statements implying a less-than-wholehearted embrace of aggressive debt monetisation. Similarly, for all of the promises of comprehensive financial reform in Japan’s banking system, the actual package announced last week minimises the promised government role in assuming much of the bad debt, thereby exacerbating the deflationary pressures already so manifest within the private sector as a result of its recent embrace of western style restructuring.

Thus, we have a scenario in which a half-hearted attempt at monetary reflation is being combined with a half-hearted attempt at banking reform, against the backdrop of a half-hearted stab at political reform, as the LDP seeks to replace the disastrous Prime Minister Mori with yet another political retread. Perhaps none of this is surprising. There is an election to be held this summer in Japan, and no politician wishes to initiate painful measures in advance of it. It is clear that much more is required and that this will probably require another crisis (whether externally or internally driven) to force the authorities to take the next step in their overall reform agenda, the ultimate contours of which are still not clear.

As far as last week’s announced banking reforms, the plan proposes that problem borrowers be split into a "good part" and a "bad part" in order to encourage greater direct write-offs. At first glance, this proposal is somewhat less deflationary than a comprehensive write-off of all bad debts, because the splitting off of individual firms into viable and non-viable businesses would allow the latter to be securitised, and sold to other parties, unencumbered by bad assets, excess employment or debt. In theory, the cash freed up from such an exercise could then be deployed by the banks to clean up the "bad parts" by using such money to offset the losses incurred through direct write-offs, and thereby preserve bank capital.

The problem with this approach is that most banking analysts suggest that the scale of the "bad parts" vastly outweighs the viable assets that might simply be experiencing short-term term difficulties. According to Nomura International Economic Research (NIER), direct write-offs of bad loans will lead to much larger than projected losses at the banks because the collateral backing of such loans (usually in the form of real estate) has become almost worthless, given the extent of falls in the value of such collateral. Urban land prices, as an example, have fallen by 80 per cent from their peak in the early 1990s. Simply adopting a proposal to write-off the banks’ debts once for all in the absence of more aggressive monetary reflation does not resolve this underlying problem and gets us back to the problem of "fallacy of composition". One bank can make write offs, but if all take this action, this simply would induce a widespread sell-off of the now fully written-off real estate collateral, and so drive down the price of land even further, likely increasing bankruptcies and unemployment and destroying consumer demand (given that real estate is still the main asset of most Japanese households). The cumulative impact of this negative recursive process would ultimately be to drive more firms to the point of bankruptcy, thereby creating more bad loans, and simultaneously reducing the value of the collateral that the banks hold against other debtors, whose assets are not yet written-off.

Given the scale of bad debts, therefore, such write-offs will inevitably pose significant new threats to unemployment, at a time when Japan’s monetary authorities have not yet committed themselves wholeheartedly to a fully fledged policy of deliberate inflation, which would help to alleviate the real costs of debt servicing, and alleviate some of the deflationary effects that will inevitably arise from such bank restructuring. As an example of the scale of the problems, NIER estimates that a full-scale restructuring of the construction industry (the source of many of the current bad debts in the Japanese banking system) would likely cut the number of construction workers from 7 million to as little as 3.5 million. Without a correspondingly more dynamic monetary strategy in place, Japan’s deflationary vortex will simply become more intense.

There is another risk posed by the proposed banking reforms in the absence of any further countervailing monetary ease. A change in the accounting rules from fiscal year 2001 (beginning in April) will force Japan’s banks to mark their equity holdings to market. Under previous accounting rules, such holdings could be valued at book cost or market-value, but under the new market value based accounting rules to come into effect, if a bank’s latent gains on its equity holdings fall below zero when prices are marked to market, the bank will be required to deduct such losses from its capital as well. The combined effect of these two proposals would be to weaken significantly the capital ratios of the banks, to the extent that it is highly unlikely that the banking system could fully withstand the full implementation of an aggressive plan to deal with the bad debt problem once and for all.

Given the market’s disappointment with the measures, the corresponding silence of America’s economic policymakers is very surprising; indeed, its non-response to the package is conspicuous. During the tenure of President Clinton, open disparagement of Japanese policy measures was almost a given; Lawrence Summers in particular was notably unrestrained in his disdain of Tokyo’s monetary and financial authorities. By contrast, in line with its new "humble" approach to foreign policy, the Bush administration has been somewhat more circumspect.

There appear to be two factors at work here. First, it is somewhat questionable whether the Bush administration knows yet what it wants from the Japanese; the only point on which there seems to be agreement among the Bush people is a greater role in regional security (particularly in light of America’s current difficulties with China which has ended all talk of a "strategic partnership" with Beijing), and it appears only a matter of time until Washington is disappointed again in that sphere (remember the Gulf War in 1991). Second, we may have reached an inflexion point in the bilateral economic relationship. For years, the American and Japanese economies have been locked in a peculiar, but ultimately unsustainable symbiotic relationship in which Japan’s domestic savings surplus was constantly recycled back to the United States, thereby keeping America’s increasingly "bubble-ised" economy afloat, in spite of the latter’s growing financial imbalances, which rendered the United States increasingly vulnerable to third world style debt trap dynamics.

We might, however, be approaching the end of such a dangerously destabilising relationship. The question therefore arises as to what replaces it, given the fundamental incompatibility right now between American and Japanese policy objectives. If Japan ultimately does get serious about aggressive monetary reflation, it appears to us that an extremely cheap yen policy is the inevitable by-product. Imagine what that would mean for the U.S., where the current account deficit is now 4.6 percent of gross domestic product—the highest ratio recorded since 1815. On the other hand, if the financial authorities do proceed with the full write-off of all bad loans in the banking system, such a policy is inherently deflationary and risks exacerbating the current global economic downturn, given the ongoing and rapidly spreading deceleration of the US economy. If one considers the alternatives available to both countries, therefore, both may have good short-term reasons to be grateful (ironically) for Japan’s traditional policy inertia and timidity.

But inertia is surely not a viable long-term solution, given the threat to growth posed to approximately 40 per cent of the world’s GDP when one considers the US and Japanese economies in the aggregate. As we get closer to crisis point in both countries, therefore, we expect policy makers on both sides of the Pacific ultimately to shed the last vestiges of the prevailing financial orthodoxy of the past 20 years and concurrently come to the conclusion that reflation of aggregate demand growth should become the dominant policy imperative for both countries. Given the scale of bad debts in the Japanese financial system, and the risks posed to Japanese Government Bonds (JGBs) if the Japanese authorities were to move toward a more aggressive inflationary policy, their ultimate solution may take the form of a predominant government role in the banking system, possibly even necessitating a temporary nationalisation of the entire sector. Given the scale of the problems we see ultimately emerging in the US credit system (particularly in the area of OTC derivatives), something comparable might be required in the US, perhaps nationalisation by another name – Resolution Trust Corp., Part II (albeit on a far larger scale than last time)? We may be only one or two growth shocks away from turning our market-driven world completely upside down. Whatever the ultimate effect of such a loss of policy inhibition, the resulting free-for-all will almost certainly keep the Keynesians, monetarists, and members of the Austrian school happily debating amongst themselves for generations to come.

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-- Anonymous, April 10, 2001