Land of the sinking sun
Nov. 4, 2002

  If Japan refuses to muster the political will to avert a looming financial collapse, the resulting disaster will be calamitous.
  Japan is No. 1 again, It was No. l in the 1980s, for all the right economic reasons. Now it has taken pride of place again for all the wrong reasons. But that shouldn't prompt any self-satisfied smirking among the rest of us.
  The numbers, like a bad traffic accident, are mesmerizing. Tokyo is first in wealth contraction, down $18 trillion, or about four times gross domestic product. It's first in real estate busts, first in financial busts (the Nikkei average is down 80 percent over the past 12 years), and first in national debt levels (nearly 140 percent as a ratio of GDP). Among developed nations, Japan is the hands down winner for having endured the worst economic slump since the Great Depression. And guess what? There's no rainbow on the horizon.
  The root of what some economists call the Japanese disease is the power of vested interests in the leading political party, the LPD. Just last week, the LPD staged a last minute rebellion against plans to deal with the huge hangover from the debt fueled equity and real estate bubble that Tokyo saw burst in the early 1990s. Banks and insurance companies were left with loans secured by assets that had simply evaporated. Since 1992, the banks have written off approximately $660 billion in bad loans. But in a weak economy, companies have continued to default, 19,000 last year alone, at a rate estimated to approach $100 billion a year. So now the banks must contemplate writing off another $700 billion. That's more than their roughly $500 billion in equity capital and reserves. Most of the insurance companies are in the same soup. They just don't have the net worth to cover their liabilities. We think we have accounting scandals? In Japan, two big insurance companies that collapsed last year had publicly stated solvency margins of more than twice their liabilities when their liabilities actually exceeded assets by 20 percent. Understatement of real financial risk is, to put it politely, endemic in Japan.
  Failed policy. The government has tried to keep the country out of a major recession by deficit spending, but it has so far failed to spark self-generating economic growth. That's no surprise: Fiscal policy has only limited leverage because most of the deficit comes from reduced revenues rather than increased pump priming or infusions through tax cuts.
  Talk about a vicious cycle. The banks can't come to the rescue of businesses with new loans because they are saddled with all the bad loans they're afraid to call because they have such close ties with companies that are basically bankrupt. Nor can the banks go to longer-term lending and make money on the spread between low short-term, interest rates and higher long-term interest rates. They compete with public service institutions that receive about 50 percent of household savings and lend for the longer term at very low interest rates.
  Some say the so called zombie companies the banks sustain should be allowed to fail, since the revenue from them would be transferred to healthy companies. But there would be huge costs associated with such shutdowns. First, the banks would face huge write downs on their loans. Second, soaring unemployment benefits would have to be paid by the national treasury, whose credit rating is already so bad that one rating agency has reduced Japan's to below that of Botswana. And the unemployment would exacerbate the deflation that has, in the latter part or he 1990s, done so much to compound the banks' hellish problems.
  Deflation is a potentially killer issue. Consumer prices have fallen every month for more than two years. Retail sales have dropped for over three years. GDP is plunging, and falling prices have driven the employment rate to the highest since World War II.
  Some argue that Japan should promote inflation, on the grounds that this would reduce the real value of debt and weaken the yen. That, in turn, would allow Japan to increase its current account surplus as a way of stimulating the economy. But depreciation of the yen would hardly be tolerated by Japan's trading partners. They would, rightly, refuse to allow Tokyo to get away with a rise in exports on the scale needed to rescue its economy. Ultimately, to contain inflation, the Bank of Japan would have to raise interest rates. That would probably bankrupt thousands of unprofitable companies, throwing millions of people out of work.
  The lack of a clear exit strategy contributes to a growing fear that the long awaited crunch may finally be near. The Japanese central bank is so worried that it recently proposed buying shares owned by the banks to provide them with funds so that they could dispose of trillions of yen in bad loans. It's unclear whether even that would be enough to end Tokyo's political paralysis. What is clear is this: If Japan doesn't do something to avert a financial implosion, the resulting damage will eclipse the Land of the Rising Sun and cast a dark pall on the economic health of the West.

Page 64     U.S.NEWS & WORLD REPORT, NOVEMBER 4, 2002