Japan's Disquieted Banks

The "big bang" that astronomers so often speak of is estimated to have occurred some twelve billion years ago. It may well be that long again before the big bang of Japanese finance and bank reform have any real or lasting consequences in the Japanese economy. This big bang was conceived by the now departed Japanese Prime Minister Ryutaro Hashimoto in 1997 to achieve a far less ambitious end than creation of the universe, and yet the desired goal of establishing a sound banking landscape has been muddled and twisting in the strange world of Japanese politics for almost three years now. Meanwhile, Japan's economy, like a hapless schooner in the ocean's doldrums, sits idle under the drag of an unprecedented decade long recession.

Further compounding Japan's problems is the Asian economic crisis that began two years ago in Thailand and quickly spread across many of the once super-charged Asian economies in Japan's back yard. This crisis, though recently displaying signs of abatement, has the potential to throw the entire world into an economic depression the likes not seen since the 1930s. Japan, the second largest economy in the world, has a key position in any overall regional economic restructuring plan to both end this crisis and inoculate against another. Recognizing this, such heavy hitters as the former American Secretary of the Treasury Robert Ruben, and International Monetary Fund Managing Director Michel Camdessus, last year put great pressure to bear on Japan to finally implement real and lasting bank reform. The success of any such bank reform in modern Japan is paramount to the future of Japan and therefore the entire world.

In today's rolling American economy and bulging stock markets it is difficult to imagine an economic crisis in far away Asia ending our own little economic miracle. Eight years of economic growth and nearly eighteen years of stock market surges have clouded the memories of much worse times before. Although the mighty American consumer may well have saved or forestalled the Asian financial crisis from becoming something truly frightening, things could easily have gone and yet may go much worse. The Asian countries hammered by this crisis account for 20% to 30% of American exports. Moreover, the domino affect of this crisis has the devastating potential to wreck havoc on all emerging world markets.

Japan, for example, invested mightily in South Korea. South Korea in turn was responsible for investing up to 15% of the foreign capitol moving into Russia. Russia is now bereft of foreign investment. As well, much of the capital inflow to other emerging markets has halted, and worse yet, capital flight has ensued. Latin America, the former Soviet republics, and scores more have been severely damaged by the crisis. Any understanding of a possible remedy to this crisis comes from an understanding of how it began. Although many of the world's leaders are looking to Japan as a possible savior, Japan alone did not cause the crisis. Rather, Japan is saddled with many of the same structural maladies that afflict many of the other Asian nations hit hardest by this flu and shares a common responsibility in ending it.

Each individual nation (hit by this crisis) had its own prescription for disaster but many commonalties in their overall economic deficiencies can be found. Crony capitalism, shoddy banking, and corruption are the primary culprits. It was easy to overlook such corrupt and backward practices when their economies were growing at a clip not seen in the history of mankind. Japan led the way with years of non-stop growth after WWII. Later, others replicated this success, adopting many of Japan's economic structures, achieving similar but not as spectacular growth. It was Japan's unprecedented growth that led to a staunch Japanese defense of the system that brought this growth about. This same system that worked so wonderfully well at pulling an economic laggard to full industrialization became stale and unsuitable once Japan reached economic maturity.

Most all of Japan's current economic woes are the direct consequence of clinging to a highly regulated, now burdensome system. In particular, the most important of all economic institutions, the banks, have been severely compromised by Japan's reluctance to reform. A Standard & Poor's account estimates Japanese banks hold over $1.27 trillion in bad loans (Butler Par. 1). This huge debt overhang is a result of huge and corrupt loan taking during a false economy in the 1980s dubbed the "bubble economy." The bubble economy was fueled by stock market and real estate growth. Later we will return to a more detailed evaluation of the current banking stock in Japan, and finally, a proposed banking and overall economic remedy.

First we will look to the political and economic landscape that led to the bubble economy and its ultimate collapse in 1990. Japan's banks acted out a crucial role throughout this economic play. Modern Japanese banks are rooted in a Western influence. This should not be surprising, as the Japanese, from the time Commodore Perry arrived in 1853, became fervent in desire and deed, to catch up to the western world around them. Reminiscent of Peter the Great's "Grand Embassy" tour of Europe nearly two hundred years prior, half of the Japanese government of 1871 undertook a two year tour of America and Europe (Pyle 85). Like Tsar Peter before them, this amazing undertaking was to learn the ways of the west.

Japan quickly emulated and adopted western institutional practice in government, schools and banking. The banks and banking system created from the 1880s to the time of WWII were established on European and American models. The Bank of Japan (BOJ) was created in 1882 as the central bank (Tatewaki 7). From this time onward, the government took an active role in using banks to promote industry. Other government-driven specialized banks followed, including the Industrial Bank of Japan (IBJ) and the Long Term Credit Bank (Prindl 6). These banks exist and dominate in modern Japan. The occupation directives following the allied victory in WWII implemented many financial changes in Japan, but overall, the banking role in growing industry grew (Tatewaki 10).

The economic system that evolved in Japan after the war was an outgrowth of the system before the war. It has been referred to as a "convoy" system. In this convoy every action has a predetermined reaction and more importantly, all the actions are directed by a highly bureaucratic system of ministries more powerful than the Japanese government itself. Japan, as a latecomer to industrial development, needed to catch up to other western countries. The convoy system they so highly refined certainly brought their economy to par with the west, and as such, it is deemed a success during the period it enabled Japan to catch the leading western economies. The most important aspects of the high growth period are subsidized protection of new industries and formation of cartels, all directed by two powerful ministries, the Ministry of Trade and Industry (MITI) and the Ministry of Finance (MOF).

Cartels, or conglomerates, were not new to Japan but the occupation had tried to breakup large family controlled conglomerations of businesses called zaibatsu. This was carried out with minimal success and a new type of conglomerate began to form with the direction of MITI even during the occupation (Johnson 205). These new "Keiretsu" and the tightly woven interrelationships they entail are the primary source of Japans present troubles. During the high growth period (1952-1973) the keiretsu system could be defended as the protector of an emerging industrialization, with a tight banking, keiretsu and MITI/MOF relationship. The system was such a seeming success, it was emulated by other emerging Asian nations, in particular South Korea.

The new banks that came from this system were instrumental in industrial growth. The Japan Development Bank (JDP) was created and eventually this bank had access to the government postal savings system, a lightly taxed personal savings system that eventually became a huge pool of capital. The JDP was perhaps the most influential of all high growth period banks, using its funds to create great new industries. As well, during the beginning of high growth, MOF tightened its hold on all banking procedure (Johnson 205). The keiretsu became groups of industry that integrated horizontally and vertically, each keiretsu developing ties with one specific bank. The bank was responsible to the industries of the keiretsu and visa versa. Such cross share holding is dubious at best and illegal in America (Johnson 205). Moreover, the banks debt risks were ultimately covered by the central bank, BOJ. In a system of overloans, the industries could borrow (from banks) more than they could repay, and the banks in turn, could borrow from the BOJ more than they could repay.

At face value this is a government system of infant industry subsidy. However, it eventually became the primary source of horrendous bank loan decision making. What began as a drive toward autarky and autonomy (because of Japan's lack of home resources) begat a Frankenstein monster that controlled all aspects of the economy. The ministries decided what industries to promote, what prices to charge, levels of production, quotas, inputs, and outputs. Virtually every step of the industrial process from natural resource allocation to finished goods reaching a consumer was guided and nudged along by bureaucratic ministers. It cannot be understated how essentially different and alien this is from a market economy of supply and demand, and more importantly, a market of competition.

The Japanese economy was stalled momentarily by the devaluation of the yen and a quadrupling of oil prices in the early 1970s. It was not long before growth, albeit slower, resumed, and Japan was well on the way to the roaring eighties of stock market growth and souring land valuations. What should be noted here is that even though this tightly controlled economic system may well have been appropriate to bring a feudal economic system to full economic maturation, the continuation of this economic puppet show would eventually bring about economic disfigurement. The banks all the while behaved like good little children, doing as the ministries bided. In Japan, bank employees are guided to follow, and disregard initiative (Wood 21). As well, the MOF guarantee against bank failure promoted worse and worse loan decision making.

The ultimate result of all this obsessive economic tinkering has resulted in the emergence of a Japanese dual economy. Dual economies are most often found in emerging nations that have developed some niche industries that resemble industries found in developed nations. Along-side the perhaps powerful economic components of the niche industries continues the more traditional and rudimentary economy of agriculture and exploitation of natural resources. Japans dual economy is not quite in this mold but exhibits a distinct duality even so. Japans dual economy is one of a dominant (but weakening) export sector stumbling alongside an entirely inefficient and weak domestic sector. Moreover, the strongest of the export sector industries are being gutted by economic pressures to move offshore.

Lacking the proper market force of competition that evolves from both importing outside goods and allowing new industries to arise, the economies of scale often became diseconomies of scale. The ever growing service sector, lacking outside competition, became wholly inefficient and non-competitive by international standards (Katz 37). The drive for self sufficiency set Japan to fostering industry in which Japan lacked comparative advantage. One example is the inefficient refining industry. Japan until recently could not import refined goods, relying on their own poor refining capabilities (Katz 33). The market economic force in most countries would lead to imports of gasoline and other refined products, keeping cost down for consumers and industry alike. Another notable example is the cost of steel to Japan's industries. With limited choice for steel, pressures mount to move offshore to those that rely on it.

The lack of imports kept industrial inputs at too high a cost. Many of Japan's most efficient export industries have therefore been forced offshore, "hollowing out" the few remaining jewels of the Japanese economy (Katz 52). The ministerial solutions to these hugely threatening economic evolutions has been to throw good money after bad. This has further weakened the banking position. Rather than spurring new competitive industry, Japan has pumped scarce bank capital into faltering, non competitive industry. As well, Japan has over invested in an attempt to grease the economy. From 1973 to the 1990s Japan invested 35% of its GDP and attained the same rate of growth as a country investing far less (Katz 71). The banks, operating on thin margins already, were finally led by MOF in the 1980s to rapidly increase the money supply in an ill-advised attempt to keep the miracle alive.

This proved to be disastrous. The move to cheap money in the mid 80s would have pleased Mr. Keynes. It certainly pleased many Japanese stock and landholders. Fast liquidity and easy monetary terms propelled stock markets and land values to rise like a Saturn rocket. The official discount rate was lowered to 2.5%, some companies were favored and could borrow at less than 4%, and tricky Eurobond/dollar swaps could make the cost of money almost nothing (Wood 12). As easy money fueled stock and land values, a fascinating economic cycle began. Holders of land and stock, which included all banks and industry, could borrow against the equity accrued in the value of that same stock and land.

This truly created money from nothing. It did super-charge the economy, but on a facade more dangerous than the debt-driven economy across the ocean Mr. Reagan was creating. Industries and banks flush with ever more capital were consumed with expansion and capital growth. The free wheeling banks made loans on the "greater fool theory" that land would continue to rise as someone else would purchase it for more, knowing in turn that another would do the same (Katz 216). The easy money fix to the problems created by the dual economy proved to be the biggest mistake the ministries had ever made. The ultimate bust of land and stock values in 1990 left the banks with huge indebtedness. The MOF disregard for accountability in banking has led Japan and its banks to a precipice that can ruin this once great economic power if it can not reform.

Before one becomes too glib about the deficiencies of one bank system to another it is wise to consider the rationale that leads to poor loan decision making. The allure of great returns historically has led bankers to disregard the soundness and validity of loans. America's banks and thrifts were hammered by the lure of huge and risky returns in the late 80s leading to failing banks and the savings and loan $500 billion debacle. Now, after rebuilding and protecting their capital, America's banks are the most solid in all the world (On Par. 3). Even so, there has been a return to junk bonds and hedge funds that have the potential to spin out of control (one such fund was recently bailed out by the government), all because of the rewards that can come from risk.

However, it is far more than risk taking that undermined the Japanese financial picture. The fundamental problems that led to the dual economy pervade the entire Japanese political economic landscape. There is a complete lack of decisiveness in government that leaves major policy in every matter adrift. The consensus driven, power broker prime ministers continually sidestep true banking reform. Only the Asian economic crisis and the very real danger it represented (and foreign pressure) brought about some of the more recent and welcome signs of putting teeth into the oft shelved big bang plan. The insistence of the opposition Democratic Party of Japan to keep the big bang on track and honest has been another positive movement.

Sadly, the recent stirring out of Tokyo on bank reform will not be enough. Public money has begun to find its way into the defunct banks. Nippon Credit Bank and the venerable Long-Term Credit Bank have been nationalized and Hokkaido Takushoku, without precedent, has been shut down (On Par.7). The new Financial Supervisory Agency (FSA) looks tougher than first expected and a great improvement over the laughable MOF supervision. Unfortunately, all the high minded plans of "bridge banks" that would ultimately nationalize and move insolvent banks into the private sector, in reality will do no such thing. Bank debts are still outlandishly huge, and the two banks recently nationalized and any others to follow will more than likely not have to cut out their debt poison but rather be weaned along like cancer patients on morphine.

Moreover, the Japanese practice of healthier financial institutions swallowing poorer ones continues. This only spreads debt around and prolongs the inevitable collapse of a bank or more likely, more government infusion of public monies. No, none of the current measures to straighten this horrific mess will truly get Japan to economic health. As much as the new plans to save banking are welcome news, compared to yesterday's plans of doing absolutely nothing, much more is needed. A financial stabilization policy should be instituted and led by the principles of free markets. A solution proposed by the Economic Strategy Institute (ESI) this year has the desired measures for true reform and is advocated by this writer.

The ESI plan envisions a number of steps starting with a Japanese government buy in to their own or similar plan, bringing it to the people, and pledging to carry it out in a fair time frame (Ito 45). The Prime Minister's office would then establish a financial stabilization committee (FSSC) that is free of bureaucratic control and directed by the prime minister. Private auditing firms need to examine the books of all Japanese banks in their entirety. The amount of bank inspectors in Japan today is pitiful. The inspectors in America number 6000, compared to only 650 in Japan (Ito 44). Once audited the bank loans should be categorized by default risk. All irrecoverable loans should be purchased by the Deposit Insurance Corporation of Japan.

Under the terms of the ESI plan the FSSC then should direct banks to write off 20% of the less risky loans and 75% of those likely to become irrecoverable. Banks will use their own reserves including equity reserves to do so. Capital ratios need to be established that include potential stock market and land gains and losses. Current ratios can sidestep such equity jumps (Ito 35). Then banks themselves need to be categorized using these ratios to establish the categorization. Banks with negative ratios should be shut down. Those whose ratios do not meet minimum requirements will be infused with capital only after committing to restructuring. The rest of the banks should be restructured and left to the markets. True restructuring means much more than current Japanese methodology, such as cutting overtime (Butler Par. 5). This plan moves great responsibility to the banks themselves, and makes the most efficient use of tax money.

The banks need to become completely transparent and corruption needs to be prosecuted. Japanese crime experts believe 40% of the bad loans in Japan are tied to the yakuza (Mafia) (Kaplan Par.4). This is disgusting and unacceptable for an economic power the likes of Japan. 1,600 were sent to prison over the American S&L crisis. In Japan the MOF and LDP, under similar circumstance could not even bring themselves to ask bank executives to resign (Katz 221). Japanese banks currently do have not real authority figures like America's central banker, Federal Reserve chairman or treasury secretary. Real bank leadership is needed. Furthermore, Japan faces a demographic problem of an aging population greater even than that in America. The ESI plan recommends a privatization of the great Japanese postal savings system (the largest bank in the world with over $2.5 trillion in assets).

The ESI recommendations or any similar big bang plan will be crippled absent overall economic reform. At this time, the banks are merely instruments of the ministries. The MOF and MITI adherence to high growth policy led to the dual economy. Weak growth due to the dual economic monster led to moves that ultimately crippled banks. Deregulation of existing industries is long overdue. Opening the economy to imports will invigorate industry at all levels with the spirit and innovation of competition. Competition in the service sector will lead to increased productivity, technological drive and new employment opportunity. Competition from foreign banking concerns is a necessity (Delhaise 211). Moreover, import competition will drive down the cost of operating large industry and stem the flow of offshore movement.

Ending the cross shareholding system and allowing foreign direct investment (FDI) will help open the door to imports. This kind of sea change in Japanese economic policy can restore Japan to greatness. In a deregulated environment of fresh FDI, import competition and renewed innovative spirit, an overhauled banking system can truly flourish. A renewed Japan would not only serve as an outstanding model for the other Asian nations mired in their own half measures of reform, but inject a sorely needed shot of capital might in the entire Asian region.

New Japanese growth, however limited by demographic liabilities (pension problems), would make huge strides in turning the fortunes of the entire Asian region to the great economic potential just beyond the horizon. A healthy Japanese economy coupled with sound Japanese banking is not just good for Japanese, but indeed, all of Asia and all the world. If the government in Tokyo can get up from its endless slumber and legislate in the interest of the many as opposed to the interest of itself, banking and economic reform can become a reality. Failing reform, the next ten years in Japan will look much like the last, with the specter of depression in Japan, and perhaps the entire world looming large.

Works Cited