Japan the Asian Argentina?

By Looking at his country, Goldman Sachs Japan chief economist Tetsufumi Yamakawa can offer little more than recounting a cynical joke that’s been making the rounds for some time in financial circles: “What’s the difference between Japan and Argentina?” Answer: “Five years.” But after international ratings agencies once again downgraded key Japanese financial institutions on February 5, that projection has to be rewritten, says Yamakawa. “Now it’s only three years, or one, or perhaps just six months – depending on how optimistic you are.”

Strangely, Yamakawa remains optimistic and rates the chances of a Japanese financial blowout in 2002 at just 25 percent. Japan will continue to “muddle through”, he thinks. Other optimistic analysts agree and count on – who?! – US president George W Bush. “This [Bush’s Japan visit starting February 17] is the perfect chance for Japan to demonstrate its resolve on the bad-loan issue,” a Tokyo market pro told Nikkei (the Nihon Keizai Shimbun business daily). But why should a 50 trillion yen (US$372 billion; low-range

estimate) problem that defied resolution in better economic times be susceptible to it now when Japan is in its third in a decade and worst post-war recession, deflation is entering a fifth consecutive year, and bankruptcies are continuing to mount?

By official Japanese government count, non-performing loans (NPLs) run at only (!) 43 trillion yen or about 8 percent of gross domestic product (GDP)

– more than double the level during the US Savings & Loan crisis of the 1980s. Private NPL estimates range from 60 trillion yen all the way up to 100 trillion yen. If that’s not enough, the total amount of bad loans – in spite of 2.5 trillion yen in bank write-offs – rose by 500 billion yen from April to September last year, because an additional 3 trillion yen worth of loans went sour during that period. “They [the banks] can try to deal with either the old non-performing loans or the new ones, but not both,” says HSBC analyst Brian Waterhouse. If Japan’s banks were subject to the same accounting standards as America’s, most would fail to meet the 8 percent Basle capital adequacy criterion needed to operate internationally. Some would even have negative capital. The banking system is technically insolvent.

Does “technical” insolvency matter? Won’t the government simply come to the rescue when financial institutions “too large to fail” are about to go under threatening systemic failure? Prime Minister Junichiro Koizumi has said as much. But even by conservative estimates, it would cost at least 30 trillion yen to recapitalize the Japanese banking system – and that would still leave the country’s life insurers, which have experienced dramatic falls in their solvency margins, in the same rotten shape as now and, of course, wouldn’t fix the real sector of the economy either.

Does Koizumi have the 30 trillion yen he may have to spend any time now? He has been saying ever since he came to power that he will cap new bond issuance in coming fiscal years to cover budget deficits at 30 trillion yen in order to impose fiscal discipline and consolidation. But in principle, the answer to the question is yes. Japan has 1,400 trillion yen (US$10.45

trillion) in household savings. All the government would need to do is transfer just over 2 percent – or a bit more while they’re at it – of that private wealth to the public sector through increased taxation. It’s easy arithmetic, but a huge political problem and idiotic economic policy in the middle of a deep and protracted recession. Don’t just for the latter reason, however, put it beyond the ruling Liberal Democratic Party (LDP) elders in their infinite wisdom to be contemplating just that in their tax-policy committee deliberations.

Now to the Argentina-style scenario for Japan. As a result of a decade of overspending by the central and local governments and concomitant failure to reform the economy, Argentina is bankrupt. Its ratio of government debt to GDP stands at 55 percent. As a result of a decade of overspending by the central and local governments in order to avoid (and hence, of course, failure of) reform, Japanese public debt stands at over 130 percent of GDP (by far the largest of any major economy in the Organization of Economic Cooperation and Development, or OECD) and according to Standard & Poor’s will rise to 175 percent by the middle of the decade. That Argentina went bust while Japan to date continues to be able to service its relatively (and, obviously, absolutely) much larger debt is largely due to a huge difference in interest rates in deflationary Japan and inflationary Argentina.

Still, there are any number of sequences of events that could lead to the detonation of the Japanese debt bomb. Here’s one: A large life insurance company fails (five smaller ones have already bitten the dust) and pushes a big partner bank to the edge of insolvency. Foreign fund managers pull out of stocks, bonds and the yen en masse. Spooked savers stage a run on the banks. Interest rates spike. The government bond market takes a nose dive. The crisis is on. Life insurers are particularly vulnerable now precisely for the same reason Japan is still able to service its debt: deflation and ultra-low interest rates. They wrote long-term policies 10 or 20 years ago with guaranteed nominal rates of return of 5.5 percent, but their current investment returns are well below 2 percent, producing a total negative spread of nearly 2 trillion yen per year. And life insurers are particularly apt to produce a crisis, because they turn to partner banks for help, buying bank shares in return for bank purchases of insurers’ debt. Let an insurer fail and the partner bank won’t be far behind. Keiretsu strikes again.

But don’t despair. A truly nasty crisis of this sort may well be the only thing that can bring Japan’s stubborn anti-reform leaders to their senses or so scare the living daylights out of its voters that they decide to kick the bums out. Unhappily, instead of a sharp crisis now, we may simply be in for more slow death before the eventual blowout, with ever worsening conseqences for the rest of Asia. As the yen continues to weaken to the cheers of policy-makers (an oxymoron in Japan these days) who are counting on an export-led recovery, exports may indeed grow a bit. But since they only account for 10 percent of GDP, the positive economic impact will be marginal. Not so marginal, however, is the negative impact of the weak yen on Asian economies from Korea to Thailand and Malaysia whose export dependencies are high. Squeezed between cheap labor China and cheap yen Japan, they will likely be forced to devalue long before the yen reaches its 147 to the dollar low point of the 1998 Russian and emerging-markets crisis. In the futile effort of saving itself and avoiding hard choices, Japan will export chaos to the entire region.

Argentina hit the wall, but the effects on neighboring countries and worldwide remained small. Let’s hope Japan will hit the wall sooner rather than later, at any rate before its pyromaniac leaders can cause a regional conflagration.




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