New OECD Study on Japan

The Organisation for Economic Cooperation and Development (OECD) has published a new economic survey for Japan. The OECD urges the Bank of Japan to ease monetary policy significantly, arguing that its existing actions have not worked and that the time has come to adopt a 'more adventurous' strategy. In the report the OECD argues that the central bank of the world's second largest economy should "move further into unchartered territory" if it is to stand any chance of bringing an end to deflation.It said the bank should raise the target range for current accounts of the banking system by considering purchasing more government bonds, expanding the range of assets it is prepared to acquire, and possibly setting an inflation target. These are measures the bank has itself described as "unorthodox", but with the reform of Japan's banking sector gathering pace consideration of such policy options is, it seems, becoming more likely.

Regarding government debt the OECD projects that a primary surplus of 1.75 per cent of GDP is likely to be necessary to stabilise the debt/GDP ratio at 180 per cent by 2010. With a primary deficit currently around 6.5 per cent of GDP, significant consolidation is therefore required. The OECD projects the primary deficit being reduced to 2.2 per cent of GDP by 2006. This of course, is a 'best case' scenario. I don't even want to contemplate what the 'worst case' one might look like.

The Japanese economy remains in a serious deflationary situation even while experiencing a cyclical recovery phase in mid 2002 underpinned by inventory correction and a sharp pick-up in exports. But the recovery is too narrowly based to represent a break with the pattern of generally low growth experienced through the 1990s. The still high capital/output ratio is likely to limit any pick-up in investment to a short term adjustment, while continuing weakness in the labour market is expected to restrain consumption growth to around one per cent per annum. More recently, a combination of factors � particularly low share prices in Japan and elsewhere, a marked appreciation of the yen and a moderating export expansion � has dampened growth prospects going into 2003.

All in all, the economy may grow by only around 1 per cent per annum to the end of 2004 with deflation continuing. But the balance of risks is now on the downside given signs of slower growth in the world economy and the possibility of a further deterioration in financial conditions, which might lead to a worsening of deflation. Thus Japan continues to be faced with the daunting challenge of radically and quickly improving the functioning of itseconomic system and halting deflation.

What needs to be done to control
public debt?

Beyond FY 2003, the central issue is whether or not Japan succeeds in placing its public finances on a credible consolidation path which would minimise the danger of a sharp increase in interest rates and increased household savings via a Ricardian effect. The OECD projects that, on a general government basis, a primary surplus of 1� per cent of GDP is likely to be necessary to stabilise the debt/GDP ratio at some 180 per cent by 2010. With the primary deficit currently around 6� per cent of GDP, significant consolidation is therefore required. In this light, the extent of fiscal consolidation envisaged in the government�s Medium-term Economic and Fiscal Perspective, agreed in January, is far from sufficient. The Perspective projects the primary deficit of the central and local governments to be reduced to 2.2 per cent of GDP by FY 2006, the end of their projection period, with a view to eliminating it as soon as possible after FY 2010. However, this involves an optimistic assumption about an end to deflation, which is unlikely to be realised in the near future. The Perspective is a small first step towards defining a medium-term fiscal policy framework. It needs to be made both more ambitious in its objectives and more concrete, and make use of shorter run real spending targets to improve credibility.

It should also spell out specific policy requirements that should guide current and future policy decisions. It needs to consider how the required revenues can be secured and spending cuts achieved against the mounting pressure for expenditure to rise, not least due to population ageing. In this respect, the heavy dependence of prefectural and local governments on the central government via public works and tax transfers, which has been a marked feature of public governance, also needs to be addressed. The government�s sense that deep changes are required in order to develop regional dynamism is appropriate. Reforms in this area will take time and should be linked with fundamental tax and expenditure reform.

Who's in charge in Japan?

As I have already indicated (see blog post immediately below) there is considerable doubt and consusion about where exactly Japan is headed right now, and about what will be the real impact of Takenaka's reform programme. Morgan Stanley's Robert Alan Feldman seem to be in no doubt:

The media were wrong. A week ago, when the initial reports on the new plan for financial system clean-up were announced, the press universally dismissed the new plan as a humiliating retreat from the hardline position that Minister Takenaka had taken. Indeed, one reporter asked me if there was anything to write but an epitaph. Nothing could be further from the truth than these reports.

It is true that immediate enforcement of US standards for deferred tax treatment (DTAs -- see appendix table 1) was not in the package. However, the package did include a review of the standards (which was not even on the agenda under the previous minister), and a clear tilt toward tightening (see appendix table 2). Moreover, virtually every other component of the initial wish list IS included in the final plan, along with some enhancements. Many of these provisions are extremely strict. In addition, the final plan includes some provisions that will enhance the sustainability of the financial reform plan.

The most epoch-making part of the plan was the new concept of "special support financial institutions" (SSFIs). The plan specifies these as institutions in distress, capital shortage, or similar situations, and says that the government and BoJ will apply "special support" immediately. Such support will trigger various actions, including FSA resident inspectors and prompt removal of "danger of bankruptcy" or worse loans to the RCC or to revival funds. Once transferred, the plan calls for prompt disposal, e.g., by RCC to accelerated collection and sales of loans purchased, with prompt sale of those loans that cannot be collected quickly, creation of a market in distressed loans, and greater use of securitization and asset-backed securities market. Of course, the FSA will have to determine whether institutions fall into the SSFI category, and this cannot be done logically until after the next round of special inspections is complete -- barring unforeseen major bankruptcies. However, the SSFI concept is a powerful one.

Now that the bashing is over, there is considerable evidence that Minister Takenaka in fact has won some very important victories. Of course, much lift is still to be done, and investor skepticism will not fade easily. However, I believe that Minister Takenaka has made a very powerful start, and that momentum is with him.
Source: Morgan Stanley Global Economic Forum
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Japanese Banks Set to Slash Lending

According to the Asahi Shimbun the toughening in Tokyo's bad-loan stance is forcing Japanese banks to react. The NBL disposal program being developed under Heizo Takenaka, minister for financial affairs and economic and fiscal policy, is supposed to make banks strictly appraise loans and set aside additional loss reserves to counter bad loans expected to surface as a result. Faced with tighter regulation, banks want to jettison loans, which count as risk assets, to prop up their capital levels. Much of the press has been skeptical about the intent of this reform, this early indication suggests that such skepticism may be misplaced, after all Japanese economic and monetary policy is caught between a rock and a very hard place. In which case watch out for the backdraft (See my blog: WILL HISTORY TREAT THE NAME TAKENAKA THE WAY IT ONCE TREATED YAMOMOTO here)

Threatened by the specter of state takeover under Tokyo's new bad-loan policy, the nation's four top financial groups plan to cut loans and other risk assets by 30 trillion yen in the current fiscal year, according to bank sources. Mizuho Financial Group, UFJ Group, Sumitomo Mitsui Banking Corp. and Mitsubishi Tokyo Financial Group will all significantly reduce their asset portfolios.To avoid hanging small, deeply imperiled corporate borrowers out to dry, and to dodge heat for crunching credit, the banks plan to scale back lending to foreign borrowers and securitize loans to major borrowers.

If higher loan-loss reserves drain too much capital, their capital-asset ratios may fall below the international floor of 8 percent, which is expected to trigger a government takeover. Assets of the banking groups carrying credit risks, including loans, totaled 273 trillion yen as of March, down 28 trillion yen from the previous fiscal year. By reducing such assets by 30 trillion yen, the banks will reduce their total risk liabilities by a greater margin in the current fiscal year.The offloading of assets is expected to bolster the banks' capital-asset ratios by about 1 percentage point.The biggest cut will be at Mizuho Financial, the world's largest banking group, which plans to shed 15 trillion yen from its asset portfolio. Sources said this is two to three times the initially planned amount.UFJ ranks second with planned cuts of 7 trillion to 8 trillion yen, followed by Sumitomo Mitsui Banking, which plans to add several trillion yen in cuts to its plan to reduce assets by 5 trillion yen.Mitsubishi Tokyo Financial, meanwhile, will slash assets by 2 trillion to 3 trillion yen.
Source: Asahi Shimbun
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I AM NOT ALONE

Having come out two weeks ago dramatising the possible consequences of a 'hard landing' in Japan in a way which may have been a little OTT for the taste of some people, it is heartening to see that one of the leading Japan 'experts' comes to similar conclusions, in a much more reserved way, of course.

WOULD REFORM RUIN JAPAN?
By Akio Mikuni and R. Taggart Murphy
An upheaval in Japanese finance, bringing with it a complete restructuring, is not impossible. But such a restructuring would produce shocks that would reverberate around the world. Japan as a nation holds nearly $3 trillion in dollar-denominated assets, many of them ultimately supported by the very deposits that would be withdrawn in a wholesale reorganization of Japanese banking. Those dollars have played an indispensable role in permitting the United States to swell its trade deficits far beyond the levels of most nations.

That so many foreigners are willing to keep their earnings from trade inside the United States banking system � what "holding dollars" literally means � helps the United States tolerate its deficits. But this situation is precisely what restructuring in Japan threatens. If banks were forced to call in loans to pay off depositors, and if those loans financed their customers' dollar holdings, Japanese companies would be forced to sell their dollars for yen. Real money and purchasing power would then leave the United States as the conversion weakened the dollar, forcing a rise in interest rates and import prices and further raising the risk of recession. That is what usually happens to countries that run excessive trade deficits � foreigners lose confidence in these countries' currencies, interest rates rise, the economy goes into recession and, as people can't afford to buy so many imports, the trade deficit begins to close. The United States has escaped this fate largely because of the very problems with Japanese finance that Mr. Takenaka promises to attack. Washington ought to be careful what it wishes for.
Source: New York Times
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