The wrong problem: Tokyo strategists think Japan's solution is to look to the U.S. 1980's example—eliminating bad bank debt. They're misreading history

International Economy, The, Nov-Dec, 2001 by Harald B. Malmgren

Listening to the heads of the U.S. Treasury, the IMF and the Bank for International Settlements, you might conclude that the single most important problem underlying Japan's economic sickness is the bad debt problem of the Japanese banks. It has been the economic focus in talks between President George W. Bush and Prime Minister Junichiro Koizumi. Even in bilateral meetings with Japanese officials to discuss responses to the terrorist events of September 11th, the U.S. Treasury insisted on taking up Japanese banks' bad debts.

Everyone knows that the bad debts of Japanese banks are huge. There are continuing arguments among policymakers and analysts about the size of bad debt because of the obscure Japanese methods of classifying debts as between "troubled" loans and truly nonperforming loans.

The truth is that the banks themselves do not know the scale of their bad debt problems. Japanese banks do not have accurate credit risk assessment capabilities, and internal information is of poor quality. Within the banks, bad news is often suppressed. Senior executives have little or no knowledge of the condition of many, if not most, of their borrowers. The Japanese government makes continuing declarations about the size of the bad debt, but its estimates are based upon the poor quality information passed on by the banks. Private sector analysts argue that the real number is some multiple of the official government estimates.

However, the current number is not as important as the trend. The Japanese economy has been floundering for more than a decade, and in 2001 has once again come into recession--a recession likely to last for several quarters, with recovery not likely until sometime in 2003. What this means is that sound loans now on the books will become troubled, and troubled loans will become nonperforming, as the economy deteriorates. Whatever the bad debt problem is today, it will be bigger in the future. There is no end in sight to the bad debts so long as the economy continues to weaken.

Prime Minister Koizumi started his leadership with a promise to clean up the bad loans, but little has happened in the months since he took office. The reason for delay is simple to understand politically: closing bad loans means shutting down businesses. Among these, the worst cases are Japan's big construction companies, which are the biggest employers in the nation, accounting for about 10 percent of all jobs. Unemployment would rise sharply if bad loans were closed out. Closing down bad loans would also necessitate government takeover of some banks, or new injections of public money into the banks. If the government fails to act, some big banks will eventually collapse, bringing collapse of additional companies and even higher unemployment.

A recent round of Japanese official explanations of the task was framed in a three-year, seven-year plan, with half the currently assessed bad debts resolved in the first three years, and the rest later. Investors in Wall Street threw up their hands, asking what would be done in the next ninety days, not in the next three years. Even more recently, a hot discussion has been taking place in the Japanese Parliament about the potential need for another round of public infusion of funds to the banks just to keep their capital base intact. And there has been hot discussion of whether the government should buy some of the bad debt, and if so, at what price.

Why is everyone focused obsessively on the bad debt problem, when Japan's economy is suffering from many other structural problems as well? The usual answer from the BIS, the IMF, and the U.S. Treasury is that the bad debts prevent banks from increasing lending to businesses, especially to new areas of activity. Banks have always been the dominant providers of funds for businesses in Japan, so this reasoning has superficial appeal.

However, it is highly unlikely that new bank loans will open the way for restructuring the Japanese economy. Right now, Japanese bankers argue that there are no creditworthy borrowers, so any money that comes along is invested in JGBs rather than placed in loans. If the government provides an infusion of new capital, the funds come right back to the government in bank purchases of government bonds.

But even if banks were willing to lend, bank loans are unsuitable for new startups, or for restructuring existing businesses. What is needed is equity capital and new sources of financing with instruments of lengthy maturity, to get businesses going, or get them past the current problems and into new modes of operation.

Kaoru Yosano, when he was MITI Minister a couple of years ago, said to me then that Japanese businessmen tend to develop strategies based upon experience in other countries. Japanese businessmen especially love to take me American template and apply it to Japanese business, often improving on the details in the process of emulation. Therefore, he suggested, what Japan most needs is to study the experience of the United States in the 1980's and early 1990's, when America restored its competitiveness.