COMMENT and ANALYSIS: Risky tango in Tokyo

Financial Times: Dec 31, 2001

The people of Argentina have seen their pensions taken away, unemployment soar, inflation jump and their industries decimated.
Nine months after being brought in to save the Argentine economy, economy minister Domingo Cavallo has resigned leaving the economy in worse shape than ever.
The news that President Fernando de la Rua has also resigned will add to the uncertainty surrounding the Argentine economy.
See also "The events that triggered Argentina's crisis" on the BBC on Dec. 21, 2001

A grim joke is doing the rounds in financial circles. What is the difference between Argentina and Japan? Five years.

Just like Argentina, Japan faces immense problems with deflation, debt and elusive economic growth. But unlike Argentina, Japan still has some time to address them. Where should Junichiro Koizumi, the prime minister, focus his energies next year? The ominous sucking sound emanating from the country's banking system provides a strong clue.

The collapse last week of the regional Ishikawa bank under a pile of bad loans is a telling reminder of the dangers of deflation in a debt-laden financial system. As the Japanese economy has slid back into its third recession in a decade, it is a story that is likely to be repeated. The fear is that more bank collapses will further knock the public's confidence, risking a systemic crisis.

The promise to eliminate the blanket deposit insurance scheme from April is already jangling nerves. Government ministers are doing their utmost to prevent any run on the banks and are talking of pumping public money into failing institutions to restore confidence. This has resulted in a public sigh of relief and a run-up in bank shares. But the Bank of Japan's aim should be preventing fires rather than just fighting them. This will still require a radical policy overhaul.

It may be tempting to blame the continuing problems of Japan's banking system on the excesses of the bubble economy. It is undoubtedly true that the bursting of that bubble inflicted terrible pain on many Japanese banks.

Few lessons learned

But the alarming aspect of the Japanese financial condition is that banks have continued to generate bad loans in recent years, suggesting that bank managers have learned few lessons from the 1990s. Unless the Bank of Japan is able to reverse deflation, the debt-servicing capability of corporate Japan will continue to weaken, wreaking further damage on banks' balance sheets.

The first priority, therefore, must be for Mr Koizumi to devise a credible macroeconomic policy that meshes measures to combat deflation with purposeful structural reforms. The Bank of Japan appears finally to have accepted the chief tenet of every central bank, namely that it can affect price levels. It is time to create some inflation by whatever means are necessary.

Explain to the public

The second priority should be to recognise the severity of the problems in the banking sector and to explain publicly how to counter them. The Japanese banking sector is liquid but not solvent. Loan losses need to be fully acknowledged and addressed. Otherwise, capital will continue to be misallocated on a gargantuan scale. This will only result in the propping up of bad companies, the harming of the good, and the further impairment of economic growth.

Given the scale of the problems, it would, as many Japanese officials have argued, be dangerous to liquidate every bad loan overnight. But a transparent and systematic plan for recapitalising the banking system needs to be developed even if this involves the outright nationalisation of some banks.

The third element should be steadily opening up the banking sector to real market forces. The ending of deflation and the emergence of higher nominal interest rates should help banks differentiate corporate credit risks and channel capital into the more productive sectors of the economy. The encouragement of foreign banks to expand in Japan would also help restore public confidence and raise professional standards.

Mr Koizumi is undoubtedly a politician of great intuition who has a unique opportunity to transform Japan. But he urgently needs to put those skills to the test in challenging vested institutional interests and overcoming Tokyo's policy paralysis. Disaster can still be avoided, but only with swift action. Without it, the spectre of Argentina looms.

[Back to my essay "Lost intelligence and responsibility of Japan's gray-haired nobilities"]

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