WSJ Review & Outlook:  [b]Fearing Japan[/b]    April 24, 2002

There was a global sigh of relief at the beginning of April as Japan's fiscal year-end passed and the country's banking system remained intact, if as dysfunctional as ever. The fear had been that if the stock market were to fall too low, new accounting rules requiring banks to record assets according to their market value might reveal some to be insolvent. As in the past, however, the government engineered a temporary rise in the value of shares to coincide with March 31, this time by cracking down on short selling, and Japan limboed under the bar, safe for another year.

Or is it? The Financial Services Agency's recent, somewhat more stringent inspection of banks' balance sheets was intended to reassure everybody that Japan is finally serious about the bad loan problem. Instead, it actually raised more doubts because it uncovered so much rot while still failing to dig very deep. Standard and Poors last week downgraded Japan's sovereign debt to AA-minus, the lowest rating among the Group of Seven nations, and Moody's is expected to follow suit with a rating that puts Japan on a par with Botswana. At the G-7 finance ministers' summit last weekend, the other members were noticeably cool toward Japan as part of an ongoing effort to convey a sense of urgency about reform.

Meanwhile, Japanese Finance Minister Masajuro Shiokawa is responding to criticism with the kind of bluster the world expects from Beijing: Other nations are "meddling in Japan's domestic affairs," the International Monetary Fund's report on the economy was "unprofessional," the ratings agencies are "impulsive" and newspapers which criticize his government's performance are "not acceptable." Such posturing only increases the suspicion that Tokyo, like the Wizard of Oz, is desperately urging everyone to ignore the man behind the curtain. Can this charade continue much longer?

The relevant concern now is not Japan's lack of growth -- after all, that is something the world has learned to live with for more than a decade, and if the Japanese people lack the will to break the iron triangle of businessmen, bureaucrats and the Liberal Democratic Party, there isn't much outsiders can do. How Japanese allocate their losses is their business. But because they in fact refuse to allocate their losses, non-Japanese have to reckon with the small but growing possibility that a financial collapse in Japan will affect institutions elsewhere.

The danger of one bank failure causing others in a chain reaction is known as systemic risk, and due to the size of its economy, Japan's systemic risk is everybody's problem. That's why prudence requires that pressure be applied to Tokyo to concentrate on one reform above all others -- stopping its banks from sweeping their problems under the rug.

That the fudging continues is not seriously in doubt, and it doesn't involve just the bad loans themselves. Consider a small item in the April 15 Nikkei Weekly headlined "Major banks, life insurers infuse capital in each other." In what the Nikkei calls a "potentially dangerous trend," troubled banks and life insurance companies are passing money back and forth between each other and calling it capital.

This is reminiscent of the common practice during the Internet bubble, when online businesses would agree to advertise on each other's Web site, with no money changing hands but the two companies booking the revenue in order to impress investors. However, in this case the financial engineering is more dangerous. Both sides may look more solvent, but their mutual dependence increases the danger of a failing life insurer taking banks down with it.

The Economist magazine last week focused on another worrying phenomenon: banks using debt for equity swaps not as a tool to resuscitate viable companies drowning in debt, but as life support for construction companies without any reasonable hope of survival. The banks aren't interested in exercising control over the companies to turn them around; rather loan officers lavish new credit on the existing managers in order to keep them treading water. The goal is to temporarily improve companies' balance sheets so that the banks' loans to them can be classified as healthy. This is an extremely high-cost way of postponing an inevitable reckoning.

One encouraging sign is the rising tide of bankruptcies. Given Japan's reluctance to restructure, these failures show that the problem can no longer be hidden and is being addressed, at least in part. Since many of the bankrupts are longtime problem borrowers that bankers and Ministry of Finance bureaucrats have been colluding to cover up for years, their final resolution represents the lifting of a burden rather than the creation of a new one. However, the bankruptcies also mean that bad loans will probably continue to rise, even after the major banks wrote off $60 billion worth last year. The combination of an increasing amount of realized losses, along with an unknown pool of hidden ones, risks unsettling the public and starting runs on the banks.

How deep is the denial at Japanese banks? The failure of giant Mizuho Bank's computer network after its April 1 debut is a symbol of a wider unwillingness to change, and the inability of regulators to force the issue. It's bad enough that, two years after Mizuho was formed from the merger of three already giant institutions, the world's largest bank by assets still hasn't been able to merge its three computer systems. But it's more shocking that, like its peers, Mizuho hasn't eliminated excess capacity in branches and employees, or adopted international best practices. A good indication of the inertia is the fact that banks are still refusing to sell nonperforming loans at market prices to the government-owned Resolution and Collection Corporation.

Nobody can reliably predict if or when Japan's much-feared meltdown will come. But consider that Japanese themselves are reading the tea leaves and are frightened enough by what they see to pull increasing amounts of their savings out of banks. They have put $300 billion of cash in home safes, about the same amount invested in mutual funds in Japan, and bought 45 tons of gold in the first quarter of the year, up from 14 tons in the same period last year. Deflation and low nominal interest rates encourage these moves, but the scaling back of deposit guarantees, which began on April 1 and continues next year, as well as the weakness of the yen, are the real driving forces.

This suggests that more of the weaker banks will be pushed to the wall and will have to be nationalized or liquidated. The specter of this unfolding in a disorderly fashion and causing unnecessary damage to the global banking system should be enough to motivate the custodians of that system to insist Japan raise its regulatory standards. The Asian financial crisis was a warning that countries which hesitate to "meddle" in their economic neighbors' "domestic affairs" can end up paying some of the cost for those neighbors' misguided policies. Out of self-interest, the U.S. and Europe should be pushing the government of Prime Minister Junichiro Koizumi to discover and disclose the true state of Japan's banks.

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Woo hoo!

Patriots is just around da corner!

Could someone paraphrase that for me.

"Patriots: The Coming Collapse", by James Wesley, Rawled (the comma is part of his name).

Or did you mean paraphrase the WSJ column??

"Japan is fucked.  Everyone else will be too."

Many thanks.

Always glad to be of service. [:D]

Longer summary:  Japan's banks are in serious trouble and are dragging down their entire economy, as well as the world economy in general.  It has been bad for a decade.  Since Japan's culture rejects admitting failure, the country is collectively refusing to acknowledge the problem.  Financial institutions are resorting to the sort of fraudulent accounting seen at American "Internet revolution" companies -- exchanging money and claiming that exchange as revenue, even though it is zero-sum (Joe gives Jim five bucks, Jim gives Joe five bucks;  doing this ten times doesn't mean they have fifty bucks each, though).  Individuals are pulling their money out of banks and putting it into mattresses because they know they're going to get screwed if they leave it in the banks -- but of course this worsens the banks' situation.  Because the Japanese economy is so large, when it finally snaps, it will damage all other world economies.