[paper] Japan - Who cares?

Gillian Tett: the former Tokyo bureau chief of the Financial Times

Gillian Tett is the former Tokyo bureau chief of the Financial Times. She is currently on sabbatical from the FT, writing a book about Japan's reform challenges, which will be published by Harper Collins next year.

As international policy makers gathered in Washington late September 2002 for the annual meeting of the International Monetary Fund, one G7 finance official made a heartfelt comment. "These days, the capacity of the Japanese government to disappoint is amazing," he chuckled, after news tricked out about the "confusion" created by the conflicting statements at the press conference of Masajuro Shiokawa, finance minister. "Just when you think that Japanese policy is really bad, it gets worse."

The remark was meant as a light-hearted aside. However, it captures a sentiment discreetly echoed in many global finance ministries and central banks this year. For though Junichiro Koizumi was hailed as a bold reformer by the international community when he took power last year, in recent months there has been a rising sense of frustration and disappointment about his apparent inability to produce rapid, coherent policies - particularly in dealing with the banks.

Now that Heizo Takenaka has launched a new reform campaign to tackle the banking issues, apparently with the backing of Koizumi, there is a new glimmer of hope that the Japanese government may finally be moving back onto the reform track again. However, Koizumi faces a momentous task if he wishes to convert the current mood of international cynicism into respect. For the perhaps the most pernicious problem dogging Japan these days is an international deflation of expectations - and concern. In public, the rest of the G7 continues to prod Japan towards reform. However, after a decade of disappointing policy packages, suspicions abound that Japan's economy could keep rotting for years. More striking still, this scenario triggers resignation, rather than panic. The brutal truth is that these days international policy-makers now have less and less respect for the Japanese government - and dwindling levels of interest. Reversing this will be a Herculean task.

To a certain extent, this dwindling interest reflects a peculiar type of "success" the Bank of Japan has enjoyed in recent years. Back in 1997, when the financial crisis first started to erupt in Japan, amid the collapse of Sanyo Securities, Yamaichi Securities and Hokkaido Takushoku, there was a genuine international alarm that a banking crisis in Japan would destabilize the rest of the world's financial system. Then, when Long Term Credit Bank ran into serious problems in the spring of 1998, there was similar concern that the jitters could spread overseas. Indeed, Larry Summers, then the US deputy Treasury Secretary, was so nervous about what was happening inside Japan that he flew to Tokyo for an emergency meeting of G7 ministers to discuss measures to deal with the Asian crisis - and the Japanese banks.

Nowadays, however most international policy makers think the systemic risks currently posed by Japanese banks are relatively low, even though the balance sheets of the banks are in an appalling state. For although financial crises cannot be predicted - by definition - Japan still appears quite well placed to calm a panic, at least in the short term. One reason is that most international investors have already tried to protect themselves from weak Japanese banks. This is a sharp contrast to 1997, as Hiroshi Nakaso, a senior Bank official, pointed out in an excellent BIS paper last year*. Back then, Nakaso explains, investors were unprepared for bank failures and under Japanese law it was not entirely clear what would happen to financial counter-parties in a case of default. In particular, the country lacked a legal framework to allow derivatives contracts to be "netted off" against each other - meaning that defaults could have conceivably created chaos in global derivatives markets. Now, however, Tokyo has put these laws in place. And although these news laws cannot guarantee that a panic would not erupt, since investor sentiment is always fickle, this framework makes the likelihood of chaos less likely.

A second reason why international policy makers are less alarmed than before is that the central bank has excellent crisis management skills – precisely because it has had so much practice since 1997. In recent years, the Bank has repeatedly stepped in to calm incipient crises - almost before anybody was aware of the jitters. It has flooded the markets with liquidity to ensure shaky banks can obtain funds. When wobbly banks have been locked out of overseas markets, Norinchukin, a quasi-public bank, has "voluntarily" offered foreign exchange services. Japanese banks have secretly used Treasury bonds as collateral to raise dollars, apparently with the Bank's blessing. These actions have prevented return of the so-called "Japan premium", or the extra cost which Japanese banks need to pay to borrow dollars overseas. Thus, unlike 1997, there is no visible sign of whether international investors are nervous about the Japanese banks. Irrespective of the banks' fundamentals, there has been an impression of calm.

A third factor which has reassured observers - or encouraged a mood of indifference - is Japan's vast reserves of funds. Quite apart from the Bank's willingness to supply liquidity, the FSA has its financial stability fund and there are enormous foreign exchange reserves, reflecting the nation's current account surplus. American observers thus assume that if a terrible crisis did ever hit the banks, the government would eventually throw money at the problem. It also means that Japan is in a radically different situation from its neighbors during the 1997 Asian currency crisis.

Fourthly, Japanese banks have dramatically reduced their international presence since 1997. Experts are divided about how much reassurance this really offers, since even after this reduction, Japanese banks' consolidated foreign exposure, in the form of loans and other instruments, still totals $1,200bn and 19 of the world's largest 100 banks are Japanese. Moreover in asset size, groups such as Mizuho are monsters by global standards and have enormous levels of international financial investments. Meanwhile, Japanese investors hold a fifth of actively traded US treasuries - leaving some US officials nervous that a Japanese banking crisis could hurt the US bond market.

However, the International Monetary Fund considers it unlikely that Japanese banks would sell their US treasuries in a panic, since they are one of the few assets in their portfolio that are actually producing returns. The IMF also thinks that the economic impact of a sharp reduction in Japanese overseas lending would be limited. For although some corners of the Asian economies might be dented if the Japanese banks suddenly withdrew their loans, the slack could soon be picked up by other Asian, European or American banks. "Any potential Japanese fall out on the regional and global financial system seems manageable - mostly as a result of the increasing de-linkage of Japan's financial system from international markets," the IMF concluded in a quarterly report in June that was closely read by many American officials.(**) Indeed, when the IMF issued the latest edition of the same report on global financial stability in late September, it appeared so relaxed about the Japanese banks that the issue barely merited any mention at all.

The "bad" news about this appearance of calm, however, it also reduces the sense of reform urgency inside Japan. Indeed, in many ways the Bank of Japan has been its own worst enemy during the last two years. By ensuring that every sign of market unease has been smoothly suppressed, the Bank has found it harder to get politicians to take its message for change seriously - precisely because there has been no sense of panic.

Moreover, as institutions such as the IMF have issued their "reassuring" statements, American and European officials have quietly lowered their expectations about what Tokyo could achieve with its policies. Indeed, after a decade of watching Japan repeatedly disappoint on the policy front, most observers tend to assume that the Japan government will fail to live up to its policy promises - almost before it delivers them.

This is not a shift that any European or American diplomat will openly admit to. In contrast, during recent weeks the US government - to name but one example - has emitted a barrage of statements calling for Japan to implement more bank reform. The Treasury and State departments have implored the country to act quickly. "Each day of waiting means that the cost of resolving the problems gets greater," Glenn Hubbard, chairman of the American council of economic advisers, recently told Japanese officials. The Americans have also tried to offer some potential models for reform. In particular, Hubbard pointed to America's own tactics for cleaning up its 1980's Savings and Loans debacle as one approach Japan might emulate. This entailed using open markets to sell bad assets to a host of private sector players. And while Americans have avoided explicit demands for public fund injections, other international observers have been more forthright. A few months ago, Howard Davies, the chief British financial regulator, took the highly unusual step of openly calling for measures to boost the capital of Japanese banks. Last month, the IMF published a report describing its policy disagreements with Japanese regulators - and demanding injections of public funds to encourage the banks to remove bad loans. "There has been enough muddling through," argues Horst Koehler, head of the IMF. "It is time for decisive action." Meanwhile, behind the scenes a number of international organizations, ranging from the American Federal Reserve, CIA, Bank of England and US State Department, have quietly held brainstorming sessions to look at the potential scenarios for Japan's economic future. "We very much hope that Japan will reform for Japan's sake," Hubbard recently added. "We have great faith in the potential of the Japanese people."

However, what these internal discussions in international institutions have often produced is considerable cynicism that the Japanese government will have the guts to actually produce the "decisive" action that is needed to revive the economy. Instead, the central scenario that many policy makers have discussed is one where Japan remains locked in slow economic decline. In this vision, the country continues to prop up hopeless banks and borrowers for another two - or even ten - years, tapping into a dwindling supply of national wealth, while bad debts keep rising, deflation rumbles and debt to GDP levels soar.

Some US observers believe that this "slow decline" scenario poses little danger for America. Thus, the main emphasis of US policy, this argument goes, should be a strategy of "containment" to stop the rot spreading beyond Japan's borders - while tacitly accepting that Japan is doomed to become more irrelevant in global affairs. Other American officials are uneasy about the implications of decline. Japan remains Washington's main ally in Asia, they point out. There is also concern than a rotting Japan could poison the region's chances of economic growth. "What worries American officials is that a weak Japan cannot be a strong political ally or gateway to Asia," argues Richard Katz, of the Oriental Economist. "Japan's problems did not cause the 1997 Asian crisis - but its weakness made it much harder to recover."

The other issue which worries some financial experts is that the longer the banking problems rumble on, the bigger the potential eventual crisis - and the harder it will be to contain the problems inside Japan's borders. If Japan keeps consuming its national wealth to prop up banks, debt-to-GDP levels could hit 200 per cent or more in a few years, and domestic investors might eventually panic. At that point, even the Bank of Japan's crisis-management skills might be overwhelmed - irrespective of how competent the Bank is at containing crises now. "In the last resort, crises are triggered by investor emotion, not macro-economic logic," argues the former chairman of one of America's largest banks. "Without policy change, it is hard to see how Japan can avoid a (crisis) eventually. It is also naïve to think this could be contained to Japan."

Indeed, Adam Posen, of the Institute for International Economics, believes that the implications of a Japanese financial crisis are so serious, that American should try to "shock" the Tokyo government into reform by using the ultimate sanction - threatening to strengthen ties with China in a form of diplomatic "Japan-passing". "The United States has a real national security interest in keeping Japan from financial crisis," he recently argued. "The US should use the now credible threat of Japan passing as the leverage. An ally should not be left unchallenged for endangering US foreign policy interests and global stability just because it is an ally and the source of danger is economic rather than military."

However, Posen's view remains a minority one. As long as Japan continues to toe the American line on security issues, the US State department seems unwilling to do anything to deliberately upset Tokyo. And while some American officials are paying more attention to China these days, this is primarily because they consider the "China issues" to be more interesting than the hitherto slow-moving "Japan" policy debates. It is no accident that the only comprehensive research institute covering Japanese affairs in Washington recently shut down.

Some Japanese politicians or bureaucrats may welcome this disinterest. After all, the penchant of the American government to hector Japan has often caused deep irritation in recent years - not least because Washington's appeals for reform have sometimes smacked of arrogance. A few years of peace from American "advice" might seem distinctly desirable in the eyes of the Ministry of Finance. However, a drift towards indifference also has more alarming implications. Would-be reformers can no longer assume that they can rely on gaiatsu, or any other external threats, to trigger the reforms that Japan so badly needs. America simply does not care enough about Tokyo to expend too much energy promoting reform in Japan - or at least not when there are so many other pressing issues on the global stage. Thus if Takenaka and the rest of the Koizumi team wish to reform the banking sector, they are going to have to find the energy and impetus from within Japan.

That is a daunting state of affairs for a country which has traditionally only changed in response to foreign shocks - or at least with the excuse of gaiatsu. Indeed, it is striking that even during the 1990's, most of the significant banking reforms only took place after a market crisis, fervent appeals from the rest of the G7 and a well-trailed meeting between the Japanese and Americans. However, unlike 1945 - or the Meiji restoration - Koizumi now needs to carve out a new path for Japan primarily on the basis of domestic pressures. Moreover, unless the Japanese government can find this internal momentum to implement serious reform, the sense of marginalization and cynicism is likely to simply grow stronger. It would be nice to hope that Takenaka can buck this trend. Perhaps by the next time the IMF holds its next policy meeting in September 2003, Koizumi's team will have dashed international expectations yet again - but this time by finally implementing some effective banking reforms.

(*) The Financial Crisis in Japan during the 1990's; how the Bank of Japan responded and the lessons learnt. www.bis.org/publ/bispap06.pdf

(**) Global Financial Stability Report. International Monetary Fund. June 2002