INTELLECTUAL CAPITAL.COM  
August 13, 1998

Is an Economic Tsunami Heading Japan's Way?

by Steven C. Clemons

The question that haunts many Japan watchers today is what happens if Japan's new leadership does everything right -- puts in place a bridge bank plan, cuts personal income taxes, moves forward to clean up the non-performing loan morass, spends a great deal on public works, and even establishes a new U.S.-like National Economic Strategy Council -- and yet the Japanese economy still slides into deep recession, pulling much of the rest of Asia into general depression?

Up until now, most of the rhetoric emanating from political pundits and market gurus has focused on what Japan needs to do to grow its economy and help absorb exports from other Asia Pacific nations hard hit by this past year's regional economic crisis. Currency traders and stock analysts watch every flinch of and utterance by newly installed Japanese Prime Minister Keizo Obuchi and his government's finance minister (and former prime minister), Kiichi Miyazawa, with as much intensity as they eye Alan Greenspan. Yet commentators may be expecting more from Japan's leadership than it can deliver.

No money to spend

A more realistic concern might be that what is brewing in the Asia Pacific is an economic tsunami. This macroeconomic tidal wave, despite Japan's profound wealth and enormous national savings, will tear down Japan's flawed, risk-ignorant main bank system and take with it much of Japan's capital-starved industry and business.

If an economic tsunami is building, no short-term measures can prevent severe economic disorder. Already, Japan has a massive liquidity crisis, driven by Japanese banks pulling yen out of circulation to cover mountains of bad debt.

Richard Koo, Nomura Research's chief economist, has argued that for every five yen deteriorating in value in relation to the U.S. dollar, Japanese banks have withdrawn approximately 1% of GDP from their lending base. In such an environment, businesses cannot access capital, their lifeblood to grow. Over the last three years, Japan's exchange rate with the U.S. has fallen precipitously from a high of 79 yen to the dollar to a low of nearly 148. If Koo is right, banks have withdrawn nearly 14% of GDP from the economy.

What is most worrisome to Japan watchers is that while any long-term recovery plan must include a credible clean-up of Japan's non-performing loans, the scale of the problem may be too big to handle. Most informed analysts realistically estimate that the banking industry's bad loan level is somewhere between $1.2 trillion to $1.5 trillion. In contrast to the United States' savings-and-loan crisis, which took 2.5% of GDP to resolve, Japan will need about 12% of GDP to overcome this economic crisis.

Several years ago, Bank of Japan Gov. Yasushi Mieno engaged in a personal campaign to compel Japanese banks to establish reserves to completely write down this non-performing debt. Some banks tentatively moved down the path he outlined; most did not. Their failure to do so has painful results. After earning minuscule returns from savings accounts at the nation's ailing banks, the Japanese public will have to foot a bill of hundreds of billions of dollars to refinance insolvent banks. This money, earning just 5% per annum, would have helped finance the next generation of problems that Japan will face due to a shrinking and aging population.

In critical condition

The dilemma faced by Japan's top leaders today is that almost any credible steps that they take will cause near term deterioration in the value of the yen. If more banks are allowed to fail, and consolidations take place -- which needs to happen -- depositors will continue to withdraw their capital and park it in home safes, postal savings accounts or foreign financial instruments. This capital flight out of Japan -- by institutions seeking higher returns and family savers who fear the insolvency of private banks -- has been a lead cause driving the yen to lower levels. In addition, if Japan tries to further escalate public-works spending and tries to grow the economy through various fiscal and monetary policy tools, Japan will undermine the yen through inflation.

As my colleague Clyde Prestowitz has written, Japan's economy is
having a heart attack, and while pumping more capital into a
system that needs bypass surgery may help the patient live a while
longer, it does not save the patient's life. However, the surgery itself
-- while good for the long term -- will cause stress and pain in the
near term.

Even with further interventions by the U.S. Federal Reserve and Bank of Japan, the yen's further decline seems inevitable. The consequences are profound. Even at present exchange-rate levels, Japan's exports -- made more competitive because of the cheap yen -- are crowding out exports from Korea and other Asia Pacific nations whose economic recovery depends on the ability to export to Europe and the United States.

Japan and Korea are both cutting into Chinese market share of global exports, thus putting serious pressure on China to devalue its currency. The fact remains that there is not enough global demand to sop up Asia's excess capacity that was foolishly financed and built up over the last decade.

The market is now bringing discipline to the region -- but the pain of the process -- the worker dislocations yet to come -- have given the majority of the world's population who live in the region the message that capitalism can be nightmarish. Civil society and the prospects for democratic stability in these countries have been shaken, and the repercussions of gutting an embryonic middle class in Indonesia, Malaysia, Thailand and Korea will be felt for decades.

Time to act

The stakes are huge. The world is hoping that if Obuchi and company do everything right Japanese consumer confidence will return to Japan and all will be well with the world. But at least in the near term, global investors appear destined to be frustrated.

If this is the case -- as so many predict -- then the attention of Robert Rubin, and his Deputy Lawrence Summers and the G7 leadership needs to be less on what Japan's government may or may not do to get back to growth, and more on how to contain the damage and insulate America and the rest of the global trading system from Japan's economic mismanagement.

In fear that such a debate might spark further market convulsions, the world's leaders seem to be waiting for the clarity of vision that an economic tsunami will bring. By that time, though, damage to the global economy may be too great for any nation or group of nations to turn around.