4/30/01

FIXING JAPAN MAY BREAK THE U.S. ECONOMY

EDITORS: Kenichi Ohmae wrote for Global Economic Viewpoint last month. Because of the election of the new Japanese prime minster, he offers this bonus column.

By Kenichi Ohmae

Kenichi Ohmae, formerly director of the Tokyo office of McKinsey & Co., is Japan's leading management guru. He is author most recently of ''The Invisible Continent'' (Harper Collins, 2000) about the new economy in a borderless world.

TOKYO -- The new prime minister of Japan, Junichiro Koizumi, has pledged to make whatever changes necessary to get Japan moving again and clean up its financial mess, no matter how painful. This is what U.S. President George Bush has said he wants. But if Koizumi succeeds in fixing Japan, he may break the U.S. economy in the process.

When former Prime Minister Yoshiro Mori visited Washington recently, President Bush prevailed upon him to attack the Japanese financial mess swiftly and ruthlessly. Face up to the problems, he was told, bankrupt insolvent companies and resolve the institutional debt problem.

Simple -- right? In the isolated and protected environment of the old Keynesian economy, this may have been an effective strategy that had little effect on the rest of the world. A borderless and interlinked economy, however, reacts differently.

When Mori returned to Tokyo, his government began to implement policies that Koizumi promises now to deepen -- in effect, cutting support systems once available to large financial companies in trouble.

Tokyo Life Insurance is a case in point. Tokyo Life enjoyed years of life support from Daiwa Bank by having its over-collateralized, poor performing loans continually rolled over despite failure to make principal repayments for more than five years. If the ax falls on these bad loans, Tokyo Life will go bankrupt. Daiwa Bank in turn will incur a huge financial loss it has not provisions to cover.

Government statistics indicate that there are at least $1 trillion worth of bad loans in the same category as Tokyo Life. To ''clean up'' this financial mess would clearly have a devastating impact on Japan, but arguably the problem would be more devastating for the United States. To cover its financial losses in its financial system as a whole, Japan will be forced to withdraw the massive funds it has invested in the United States to take advantage of higher interest rates and that have played a key part in propping up American prosperity.
There is little doubt that once President Bush witnesses the effects on the United States of his recipe to cure Japan's ills, he will promptly reverse course.

The Japanese Financial Crisis -- The Bottom Line Problem
Most of cause of Japan's financial crisis lies with the incorrect classification of debts and a subsequent and severe under-provision for bad and doubtful lending. By law, Japanese financial institutions are required to classify loans as follows:

Class 4: Effectively bankrupt companies for which banks must provide a 100 percent reserve (but not necessarily write off).

Class 3: Companies in danger of bankruptcy for which banks must provide a 75 percent reserve.

Class 2: Non-performing (interest payments in default for more than three months, which require a 50 percent reserve.

Class 1: Low probability of default in which no reserves are required.

In drafting these provisions the government failed to assign clear definitions. The wording uses ambiguous phrases such as ''needs attention,'' ''in danger of bankruptcy'' and ''effectively bankrupt.'' Hence, individual banks have had the discretion to classify and build reserves as they like, depending on their interpretation of the law. Needless to say, non-performing loans have been severely under-reserved.

Nearly 10 years ago the amount of failed loans were in the $2 trillion range, primarily due to the sharp drop in Tokyo's land prices that fell to only one-fifth of their 1989 peak value. The extent of the optimism in the property markets and the incompetent lending practices of the financial institutions during Tokyo's property boom are almost comical.

Over the last 10 years, we managed to clean up only $1 trillion of these bad debts, so there is still another $1 trillion to go -- and these, by definition, are the hardest to clean up. Prompted by the enforcement of International Accounting Standards (IAS) this year, for the first time in Japanese corporate reporting history, assets and liabilities will have to be disclosed at their fair market values. Some of Japan's best-kept secrets will be finally be revealed.

An Honest Review of the Last Decade
The U.S. government, industry and individual American consumers have long been the beneficiaries of Japan's instability. The loss of confidence in Japanese financial institutions and in the Japanese economic system drove Japanese institutional investors offshore -- mostly into dollar-based instruments.

The capital flight out of Japan and into the United States was then accelerated by the Clinton administration's ''economic advice'' to Japan to lower interest rates, increase public spending and stimulate domestic demand.

The Japanese government yielded to these demands rather than implement policies to promote capital coming home to Japan to solve its own financial problems. Japan minted more money to stimulate demand and kept interest rates close to zero to prevent capital flight out of the United States. The ''Greenspan magic'' of widening the interest-rate gap between the two countries and engineering market stability further encouraged capital influx to the United States, which in turn strengthened the dollar and inflated the U.S. stock markets. The extent of linkage between Japan and the United States was well understood by the Clinton-Greenspan team.

An Honest Review of the Existing Situation
Interestingly enough, this savvy awareness of the interlinkage of the Japanese and American economies does not seem to have transferred to the Bush administration. Clinton's micromanagers knew well the potential dangers a real cleanup of the Japanese financial institutions would have on the the ''new economy'' of the United States.
If Koizumi succeeds in his fulfilling his promise of finally making change in Japan, President Bush will get a stern wake-up call indeed.

America no longer enjoys the super liquidity it had until only recently. Over the last year, the Nasdaq has deflated by 65 percent, which equates to about a $4 trillion loss. Some 80 percent of Americans have investments in the stock market, either directly or through mutual funds or through their pension funds. Yet, consumer debt is very high because spending was fueled over the years both economically and psychologically by the handsome growth of their assets.

Asset deflation of this magnitude for the average American is thus very painful. In fact, it dwarfs Bush's $1.6 trillion 10-year-long tax-cut campaign promise. It is no wonder that the American consumer has not reacted well to the tax-cut proposal or Greenspan's recent interest-rate manipulations.

It is against this background that Japan must digest its remaining $1 trillion in bad credit. Since the entire Japanese GDP is only $5 trillion and tax revenues are only $0.5 trillion, there is simply no way it can do that without Japanese financial institutions pulling their money out of the United States.

Inevitably there will have to be a huge capital exodus, a homecoming of the Japanese money that has been tied up for 10-plus years, financing the U.S. budget deficit. The result? The U.S. economy will experience a liquidity crunch, and both the Japanese and U.S. economies will decline further.

I predict that Wall Street investors will escape and take money out of their home country without hesitation into, for example, euro-denominated securities. This in turn will prompt the dollar to fall, accelerating further capital flight out of the United States.

An End to the American Magic?
The ''American magic'' over the last 10 years, though based in the vaunted entrepreneurial culture, has been inflated by the gaps in stability and interest rates with the rest of the world, particularly with Japan. The necessary capital flight back to Japan will cause a major market correction to adjust the economies to their equilibrium values.
This market correction will allow America to finally realize just how much of its asset appreciation was due to support from the rest of the world. Real asset values will be revealed.

I believe that the Dow will decrease by one-third from its peak. When the Dow was 12,000, it would have been 8,000 without the influx of foreign capital.
Who will suffer the most?

The capital flight back into Japan will be close to $550 billion, of which $320 billion is in Treasury bonds. The Japanese hold approximately 10 percent of all outstanding U.S. government securities -- more than any other single country.

The highly leveraged American consumer market is more vulnerable to a slowdown than Japanese consumers who have not been as euphoric as their stock-weighted American counterparts.

The Japanese are prepared for the worse possible case. Americans are not. The Japanese consumer is comparatively resilient. Liquid household savings are high and borrowings are low. Only 8 percent of Japanese households invest in the stock market. So a market correction of the Nikkei has had minimal effect on the average Japanese consumer.
Unemployment may go up due to a series of corporate insolvencies, but an increase from 4.9 percent to a two-digit level will not cause panic. The tradition of Japanese households is to look after each other, covering at least three generations in a household.

The pinch, however, will be felt multiple times over by Japanese financial institutions.

Among other losses, institutions will have to book significant foreign exchange losses as the yen/dollar exchange rate has moved from 235 to 125 since U.S.-denominated bonds were originally purchased in the early 1980s. Once capital flight occurs, the dollar will further decrease, causing even larger foreign exchange losses. This will not defer the capital exodus as liquidity will be a far more important issue than currency losses.
Forty-five percent of stocks traded on the Nikkei are held by Japanese financial institutions and closely held corporate groups. Their balance sheets will continue to hurt as the Nikkei corrects to its real value -- from a 10-year high of 38,000 to, say, 9,000.
The next two to three months will see all this happen, and in just as much haste Bush will change his orders and reissue a command to Japan's leaders to put the brakes on change just as Clinton did. One big difference will be that Greenspan will probably go to the Congress to blame U.S. instability on the Japanese depression, never mentioning that it was Japan that subsidized the long American euphoria that has now come to an end.

(c) 2001, Global Economic Viewpoint. Distributed by the Los Angeles Times Syndicate International, a division of Tribune Media Services
For immediate release (Distributed 4/30/01)

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