Waiting for Japan’s typhoon to pass by

Economist 11/29/97

THIS has been a miserable year for the Japanese economy. First came the squall from the unexpectedly savage effects of raising taxes in April. Then the currency storm blew up in Thailand, the Philippines, Malaysia and Indonesia. But until
earlier this month, the worst seemed to be over. Most private economists, not to mention international experts such as those of the OECD, had thought that economic growth would pick up in 1998.

That was before South Korea’s precarious financial system imploded, forcing a devaluation of the Korean currency, the won. Now, with the crisis in its own financial system, Japan is facing a full-blown typhoon. Analysts are drastically revising their forecasts downward. And whether or not authorities have the courage to resolve the problems of its banks, brokers and insurers quickly, one thing is certain: Japan’s economic model has been changed irrevocably.

When the crisis was confined to South-East Asia, the effects on the Japanese economy were significant but limited. Only a little over 12% of Japanese exports go to that region. And since the exports of those countries are broadly different goods from those of Japan, devaluations in their currencies would have little effect on Japanese exports to Europe or America. Japan was worried mainly because its banks are big lenders in South-East Asia, especially in Thailand.

South Korea is a different and much bigger story. It exports a range of electronic gadgets, cars and semiconductors which compete directly with Japanese goods. Now that it has been sucked into the vortex and the won devalued by 20% against the dollar, the prospects for Japanese exports look a lot less rosy. That matters a lot. Surging exports, particularly to America, on the back of a sinking yen, have been almost the only source of economic growth in Japan this year.

If exports flatten out, Japan will have to rely more on domestic demand to drive growth. The trouble is that domestic demand, both from consumers and corporations, is anaemic. The financial crisis is likely to make it more so.

The direct wealth effects of the crisis are the least of it. Relatively few Japanese have money in shares, either directly, or indirectly through investment trusts, Japan’s version of mutual funds. It is therefore unlikely that consumers will stop spending because a sagging stockmarket makes them feel poorer. 

The indirect impact on consumer and business confidence is harder to assess. Confidence was, in any case, pretty meagre. One way to see that is to look at appetite for risk, which is already almost as low as it is possible to get. Witness the desire to invest in long-term government bonds despite the fact that they offer the lowest yields (less than 2%) in recorded history. And witness the split in the stockmarket between blue-chips such as Toyota, whose capitalisation is still three times that of the big three American car makers put together, and small, primarily domestic companies traded on the over-the-counter market, some two-thirds of which are trading for less than the net value of their assets. The queues of depositors outside some Japanese banks suggest that confidence has, if possible, got worse still.

A third possible consequence of the financial crisis is a credit crunch. Seeing their own capital base eroded and their borrowing costs soar, banks are far less willing to lend to any company that is faintly risky.

This is certainly not a problem for big manufacturers, which are spinning off record amounts of cash and are strong enough to borrow in the international capital markets. For other firms there is more evidence. Construction companies, for example, are finding that banks have cut off their credit lines, which is why bankruptcies in the construction industry have soared. Small and medium-sized firms in all sorts of industries are griping about banks’ unwillingness to lend.

One way to understand this is that banks with weak capital bases are unwilling to lend to risky firms. But another way of looking at the tightening of bank lending is simply to say that capital is being allocated more efficiently. This is precisely what the ongoing reforms of Japan’s financial sector are supposed to achieve. For the first time bankers are taking a close look at the credit quality of borrowers. “They are no longer like inexhaustible piggy banks,” says Betsy Daniels, an analyst at the Tokyo branch of Morgan Stanley. And, naturally, the worse their credit, the more companies must pay to borrow.

Two things follow. The first is that bankruptcies will rise sharply. The second is that, as a result, so will unemployment, which is already at the high rate—by Japanese standards—of 3.5%. The only quick exit from this would be tax cuts for both individuals and companies. Enthusiasm for either is distinctly lacking at the finance ministry, which is why the prospects for the year ahead look so grim.

For all its troubles, Japan has not lost its enviable strengths: highly skilled workers, productive research labs, and companies that churn out things that people in other countries want to buy. Many Japanese businessmen are eager to leave the days of heavy-handed government guidance behind in favour of hard-knuckled competition. If the government is finally willing to set the  financial system to rights, it would not be difficult to imagine the typhoon turning out to be a divine wind, a kamikaze.

Japan’s financial system is melting down. It is unclear whether the government can act quickly enough to stop it

NO, SAID both the governor of the Bank of Japan and the finance minister, with straight faces, Yamaichi Securities was not insolvent. Why, then, did Japan’s fourth-largest securities firm announce on November 24th that it would be closing? Yamaichi is done for, and everybody knows it. Plenty of other financial firms should be considered insolvent too. Six years after Japan’s once-powerful banks began drowning in losses, the government at last seems prepared to let bad banks, insurers and stockbrokers fail.

Earlier this month, Sanyo Securities, a middling securities firm, went under. On November 17th, Hokkaido Takushoku, a big commercial bank, followed suit. This week brought the collapse of Tokuyo, a tiddler, while Ashikaga, a big regional bank, begged its biggest shareholder, Bank of Tokyo-Mitsubishi, for assistance. No one thinks that these will be the last. Queues are forming outside weaker banks as worried depositors pull out their savings. Confidence in the financial system is collapsing.

So serious has the crisis become that, at last, politicians and the finance ministry are discussing a subject long forbidden: injecting public money into the system. On November 27th, after much dithering, Ryutaro Hashimoto, the prime minister, said that public funds would be used to solve the banking system’s woes. But although that principle is now accepted, Mr Hashimoto has yet to put forth details. Whether the government can deliver a package that is both big enough and of the right sort to fix the financial system’s problems remains an open question.

Yamaichi’s demise has been the immediate catalyst in this crisis. Once the biggest securities firm in Japan, the company’s straits have been no secret: it has lost money in four of the past six years. But even as Yamaichi’s problems mounted, it was widely assumed that the finance ministry would quietly arrange for a bank to take it over. The decision to allow a firm of Yamaichi’s size and stature to fail came as a shock. More shocking still was the news that it had hidden huge losses from regulators by setting up dummy companies in the Cayman Islands. According to preliminary investigations, these amounted to ¥264 billion ($2 billion). There is more: according to a senior official at the finance ministry, “Yamaichi may have used investors’ money for its own purposes.” The amount involved is not known.
Financial authorities feel the need to maintain the fiction that Yamaichi is solvent for three reasons. First, the Bank of Japan is not supposed to lend to insolvent institutions; insolvency would have made it hard for the central bank to lend Yamaichi the money to settle outstanding trades and to return investors’ assets.

Second, if it was insolvent, the authorities would have to dip into the Compensation Fund for Deposited Securities to repay investors, but the fund itself is almost out of money. Third, an insolvent Yamaichi would also be declared bankrupt, allowing the courts to seize control of its and clients’ assets. That might make already jittery investors panic and could delay the settlement of deals still in the works, snarling up payment and settlement systems.

Other securities firms have indulged in similar practices to Yamaichi’s. Many are probably as “solvent” as Yamaichi proved to be. “It will not be the last to fail,” says the finance ministry official. Indeed, if Yamaichi hid losses of such magnitude, investors reasoned, other firms may also have something nasty in the woodshed. On November 25th, the first day of trading after Yamaichi’s collapse, the Nikkei 225 average fell by 854 points, or 5.1%. Shares in all but the strongest financial institutions fell sharply again the next day. Although Daiwa Securities, Japan’s second-largest broker, said on November 26th that it had no
off-balance sheet losses, that did not stop its shares from falling by 20% more. Those in Nikko, the third-biggest broker, fell by almost as much.

Dramatic as they are, the problems at Japan’s brokers are insignificant compared with those of banks and life-insurance firms. Stockbrokers hold only a small amount of investors’ savings, as shares account for only 4.5% of household financial assets. In contrast, 15.9% of household assets are on deposit at banks, and 10% are invested in insurance policies.

About those guarantees . . .

Thirteen of the 19 biggest banks expect to report losses this year as a result of writing off bad loans. This week several big banks claimed yet again that the worst of their bad debt problems are behind them. Given the opacity of the banks’ accounting, however, the markets do not trust this. The bigger, healthier banks will survive: shares in Tokyo-Mitsubishi, for example, have suffered little in the recent carnage. But investors are now dumping shares in any bank that has the remotest whiff of risk—particularly because the failure of Hokkaido Takushoku has made it clear that the finance ministry’s “guarantee” of the top 20 banks applies only to depositors and creditors, not to shareholders.

Even creditors are now none too sure about the worth of the ministry’s guarantee. This has pushed up the banks’ cost of borrowing. The “Japan premium”, the extra rate at which Japanese banks must borrow in dollars compared with their healthier foreign counterparts, has risen to between half and one percentage point this week. For Nippon Credit Bank, it reached four
percentage points. Some weaker Japanese banks are finding it prohibitively expensive to borrow even in yen. Few, if any, foreign banks will give them credit lines, and healthy domestic banks are refusing to lend to their weaker brethren. Nobody wants to buy the debentures issued by any of the long-term credit banks. The weaker banks can get cash only from the Bank of Japan, which now has ¥3.6 trillion in loans to the banking system compared with just ¥373 billion at the end of October.

Small wonder that shares in troubled banks have tumbled. Those in Yasuda Trust, which is part of the same keiretsu as Yamaichi, fell by 28% on November 25th as its debt was downgraded to junk by Standard & Poor’s, a credit-rating agency. Shares in other big and deeply troubled banks such as Nippon Credit Bank, Long-Term Credit Bank and Daiwa Bank, fell as much. And they all fell further the next day. The market capitalisation of some of the weakest halved in two days. “The markets are engineering the shutdown of banks . . . and that is very dangerous,” says James Fiorillo, an analyst at ING Barings.

Mutual life insurers are in similarly dire straits. Not only are they the biggest holders of bank shares, but life insurers have given some ¥434 billion in subordinated loans to brokers, and a whopping ¥14 trillion to banks. Subordinated loans are not covered by the finance ministry’s guarantee. Should more banks and brokers go bust, life insurers are unlikely to get this money back.

They are anyway in a pickle. Andrew Smithers, an independent London-based economist, reckons that, taken as a whole, the life-insurance industry is insolvent. Big companies, such as mighty Nippon Life, are reasonably robust. The smaller ones are anything but. One, Nissan Life, has already folded this year. Low interest rates, a mass cancellation of policies (which eats into cashflow) and a sinking stockmarket (which eats into unrealised gains on their equity portfolios), already mean that they are suffering a severe shortage of available funds. Some insurers own large amounts of American Treasury bonds, and there are fears in America that they will dump these to raise cash. This seems unlikely: firms that hope to survive have no choice but to hold on to their Treasuries, their most high-yielding assets at present.

The jitters of politicians and bureaucrats are understandable. For the first time since the beginning of 1996, when the finance ministry pushed through a highly unpopular package to liquidate seven huge mortgage companies, there is talk of using public money to solve the financial crisis. Politicians feel that the public fright over financial failures will override objections to bailing out the banks.

The form that such public money would take is still undecided. One option is to set up a version of America’s Resolution Trust Corporation, which inherited and sold off the assets of failed savings and loan associations in the early 1990s. A second option, increasingly favoured by the ruling Liberal Democratic Party, is to inject funds into the Deposit Insurance Corporation. Where it would get the money is unclear. One possible source is bonds guaranteed by the government. These would be bought by the finance ministry’s trust-fund bureau, which manages ¥400 trillion of deposits in the postal savings system. A seemingly more favoured option is to get money directly from the Bank of Japan.

How the money is injected is, in some ways, academic. The Deposit Insurance Corporation would not have the power to investigate banks and shut down those it deemed insolvent. It would only be able to dispose of banks’ assets once they had gone bust. This creates a problem more serious than the one it purports to solve. Without clarity as to whether bad institutions will be closed, the capital markets will force all but the strongest of banks to pay a huge premium to borrow money. That may drive even relatively healthy banks to the wall. In a sign of just such a development, shares in Fuji Bank—by no means the worst-off of Japan’s banking giants—did not trade for two days this week, so concerned has the market become about its health.

Worse, politicians, whatever their newfound commitment to using public cash, seem content to fiddle while Rome burns. The details of the Liberal Democratic Party’s scheme will not be announced until December 10th. Nothing is likely to become law until mid-January. Without huge injections of money from the Bank of Japan, a lot of institutions could go bust by them.