Japan In Deflation?

Imagine Moody's threatening to downgrade the AAA sovereign rating of the world's biggest creditor nation! But that is the prospect the new Japanese Prime Minister, Keizo Obuchi and finance minister Kiichi Miyazawa, face on coming to office. Both are seasoned, if colourless, Liberal Democratic Party politicians, not much known for their reformist fervour, coming to office at a time when radical measures are needed to get Japan out of the recessionary mire it is wallowing in.

The 78-year old Miyazawa, in an earlier incarnation, had famously declared the demise of Japan's economic malaise as far back as 1992. Unfortunately, the problems refuse to go away. And the worldwide accolades Japan was receiving hardly a decade back for its economic prowess have now turned to vilification with every western leader lecturing them on how to run their once miracle economy.

 

Unemployment has, for the first time in memory, crossed US levels. Vehicle production was down 10 per cent in June. The January-March quarter witnessed the economy slowing down by 1.3 per cent, or an annualised rate of 5.6 per cent. Since this is the second successive quarter in which GDP has fallen, the economy is now in recession in terms of the customary definition of the word. Japan faces a drop in annual GDP for the first time in 25 years.

To be sure, Japan has been experiencing slow growth through the decade of the 1990s _ and this despite successive fiscal stimuli to finance huge public projects. But many of these have led to construction of roads and bridges that hardly anybody uses, concreting of riverbeds, and similar outlays that help put spending power in the economy, but do precious little for sustained growth. The budget deficit is running at around 6 per cent of GDP. But the consumer refuses to spend, preferring to stash money against an uncertain future.

If fiscal measures are not working, monetary policy also seems to be helpless. For a long time now short-term interest rates have been of the order of 0.5 per cent but even this has not stimulated economic activity. One result of the ultra-low interest rates has, of course, been the weakening of the currency. Recently loosened exchange controls, allowing residents to invest abroad, are putting further pressure on the exchange rate. A few weeks back, the US Federal Reserve Board joined the Bank of Japan in intervening in the exchange market by buying yen to support the currency.

This had some temporary impact taking the exchange rate up from JPY 145 on June 15, 1998 to JPY 136 on June 18. But the currency has since slipped back to JPY 144.5 at the time of finalising this article.

In theory, the low exchange rate should help exports. To an extent it is doing so. The trade surplus in the first half of 1998 at $ 47 bn, is 66 per cent higher than the corresponding period last year, but more because of a fall in imports. Export growth has not been enough to make a significant impact on the level of economic activity, partly also because major markets for Japanese goods in east Asia are themselves in the throes of recession.

To an extent the fall of the yen against the dollar exaggerates the weakness of the currency. This is because exchange rates of major trading partners in Asia, from Korea to Indonesia, have fallen even more. On a trade weighted basis the yen is not as weak as the dollar:yen rate indicates.

Nevertheless, the weakness of the yen is a major problem for east Asia. If it persists, at some stage mainland China may be forced to devalue the yuan, which in turn will exacerbate the problems in east Asia.

While in recent years the Japanese authorities have done all they could in terms of fiscal and monetary policy to revive the economy, hitherto atleast they have been fighting shy of tackling the problems of the banking system in a resolute fashion. Increasingly, it seems that unless radical, and costly, steps are taken to tackle the problem of non-performing assets of the banking system, the economy is unlikely to revive.

The extent of the problem is truly staggering. Japan's Financial Supervisory Agency has recently estimated that as of March 31, the so-called category two and three loans of the 954 deposit-taking institutions totalled about $ 625 billion. This is over and above category four, i.e. bad, loans which are estimated to be around $ 250 billion. Together, the various categories of non-performing assets are of the order of 25 per cent of GDP. The score could go even higher as Japanese banks have lent as much as $ 80 billion to troubled east Asian countries.

A positive feature is that for the first time the true extent of the problem has been acknowledged, which is necessarily the first step in trying to solve it. Most of the bad debts have arisen because of the fall in asset markets _ both real estate and equity, since the beginning of the decade.

If the weak economy persists, the problem can only get bigger. What is now proposed is that the Financial Supervisory Agency will examine all banks and determine the extent of problem loans in each. Those that are considered non-viable will be taken over by a so-called "bridge bank" . The latter will function under the Agency which will appoint new managers to supervise the working. The idea would be to dispose of the bad assets, obviously at losses which will be borne by public resources, and sell or merge the remaining "good banks".

The first test is likely to be the Long Term Credit Bank of Japan (LTCB). A once stellar name, LTCB is staggering under a JPY 1.4 trillion portfolio of NPAs. There is an agreement in principle to merge with Sumitomo Trust but the latter will not take over the NPAs. What east Asia, including Japan, is emphasising is the paramount need of a healthy banking system. India, beware!