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Japan on the brink

The attacks on the US have added to the troubles of the world's second largest economy. Wide-ranging measures are needed if it is to avoid a harsh recession, says Gillian Tett - Oct 02 2001 00:00:00

When Masajuro Shiokawa, Japan's 79-year-old finance minister, was quizzed on Japan's economy on Monday, his verdict was sober. "Very bad," he declared, after the Tankan survey of companies showed a sharp fall in business confidence. "Looking ahead, I don't see things being so bad," he added, "but the economy is at a critical juncture."

That is an understatement. For while global policymakers have focused on the slowdown in US growth since the attacks of September 11, the world's second largest economy has been slipping back towards recession. The US is an important export market for Japan and it would be badly affected if American consumers stopped spending. "A downturn in the US economy would have serious effects on the Japanese economy," warns Eisuke Sakakibara, former vice-finance minister.

Japan's predicament is particularly severe because it is now suffering from both cyclical woes and structural flaws. A downturn in the business cycle has coincided with fragility in the financial sector and a bout of deflation. That has broad implications for the rest of the world, given the size of Japan's economy.

Although Junichiro Koizumi came to power as prime minister in April promising to save Japan's economy through "structural reform", there are few short-term solutions. Manoeuvre in fiscal policy is limited because Japan's ratio of public sector debt to gross domestic product is already the highest in the industrialised world.

With overnight interest rates now virtually at zero, the monetary policy options are also limited. When the Bank of Japan injected Y10,000bn (£56bn) into the money markets last week - more than double the usual level - investors barely responded. "There is a ticking clock in Japan now," says Paul Sheard, chief Japan economist at Lehman Brothers. "There is a nasty interaction between the real economy and the financial sector."

The economy was looking fragile even before last month's attacks. Japan is not technically in recession yet. Although the economy contracted by 0.8 per cent in the second quarter of the year, it grew slightly in the first quarter. But business inventories are at cyclical highs, investment has been tumbling and industrial production fell in August at its fastest annual rate since the 1973 oil shock. Most economists now expect further deterioration given that last month's events threaten to undermine exports to Asia and the US.

The attacks has also added to Japan's decade-long financial woes. The falls in global stock markets after September 11 dragged Japan's Nikkei 225 index down below 10,000 for the first time since 1983 - just before the close of the first half of the financial year on September 30. Japanese accounting rules require banks to revalue their assets, including their equity portfolios, at the end of the half-year. At Friday's close, the Nikkei was about 25 per cent lower than in the same period six months earlier. Since Japanese banks hold a large part of their net assets in equities, this has eroded the value of their capital base.

To make matters worse, this is occurring just as Japan is tightening its accounting standards and forcing banks to crystallise more of their loan losses in their balance sheets.

This situation is not in itself a crisis: the Financial Supervisory Agency, the main regulator, on Mondaym estimated that the large banks' capital adequacy ratios will remain above 8 per cent of risk-weighted assets - the minimum set by the Basle committee - in their half-year results. But the decline in capital comes at a time when banks need a cushion. The level of bad debts is rising once more, 10 years after the banks's balance sheet problems first emerged.

This partly reflects the fact that bankruptcies tend to increase during an economic downturn. But it has been exacerbated by another critical challenge - deflation. The gross domestic product deflator, a broad measure of price trends, has been almost continually declining for eight years, creating cumulative price falls of 6 per cent since 1994. This means that the overall economy has been contracting in nominal terms, irrespective of brief increases in the rate of "real" GDP growth. In nominal terms, Japan's economy is no larger than in 1995.

Most Japanese consumers find deflation welcome, since their spending power is rising. But deflation is proving disastrous for public sector finances, since a flat or shrinking economy is making it hard to reduce Japan's national debt, which is running at 130 per cent of GDP and rising. Standard & Poor's, the credit rating agency, warned last week that its former projection that national debt would hit 175 per cent of GDP in four years now appeared too optimistic.

To add to these woes, deflation is also hurting banks. As prices fall, it becomes ever harder for heavily indebted companies to repay bank loans. "Banking is a lossmaking business right now," warns Masaaki Kanno, a former Bank of Japan economist who now works at JP Morgan. He says banks' lending margins are too small to compensate for the amount of capital they must sacrifice to write off their bad loans.

Can Mr Koizumi and Mr Shiokawa find a way out of this mess? Some analysts say the first imperative is to tackle the financial woes by using public funds to write off the banks' bad loans. But Japanese banks retort that deflation and recession must be stopped first. "Deflation is the fundamental cause, not the result, of the bad loan woes," argues a recent discussion paper by Industrial Bank of Japan.

Meanwhile, the Bank of Japan and Ministry of Finance are locked in their own policy debate. The ministry says it is imperative for the bank to loosen monetary policy as a first step towards combating deflation. The bank says that monetary easing would be ineffective unless there were structural reforms first. "What we need is a type of creative destruction, real structural reform," says one official.

Most economists suspect that a combination of such measures is required. "I don't think there is any single magic wand or one single solution," says an official of the Group of Seven industrialised nations recently. In practical terms, this would imply a combination of a very loose monetary policy to halt deflation, combined with radical structural reforms to remove bad loans and close down the uncompetitive parts of Japan's economy.

The good news is that this type of "balanced" policy mix is what Mr Koizumi's team says it wishes to achieve. Mr Koizumi is now talking about both the need for structural reform and flexible measures to boost demand. Some economists hope that last month's attack might even give Mr Koizumi a fresh mandate to implement reforms. Jesper Koll, of Merrill Lynch, says the prospect of a downturn is creating a "more pragmatic policy response".

The bad news is that, just as the shock of last month's events could be used by Mr Koizumi to promote radical reform, it could also be used by his opponents as an excuse to delay it. Despite Mr Koizumi's rhetoric, he has delivered few reforms so far. Optimists insist that this simply reflects a sensible process of planning and argue that the Koizumi team is now preparing a broader co-ordinated plan that mixes structural reform with measures to support the economy. But even so, it will be hard to implement this type of co-ordinated policy mix in a country where power is so fragmented.

Moreover, while the rest of the industrialised world might have accepted a deep recession in Japan last year if this helped to make the economy more competitive in the long-run, the level of international tolerance is diminishing. "The world cannot afford to see a deflationary spiral in Japan," says the G7 official. Mr Koizumi and Mr Shiokawa face hard policy choices. With the rest of the world on the edge of recession, many analysts are sceptical about their chances of success.

© Copyright The Financial Times Limited 2001.