Korea: Challenge and Opportunity for Japan

Date June 11, 2002
Speaker Marcus NOLAND(Senior Fellow, Institute for International Economics (IIE))
Material Handout 1 [PDF:28KB](Handout 2 [PDF:17KB])

Summary

It's Korea week. First of all, Korea is co-hosting the World Cup with Japan. This is a constructive development. Second, I am in Japan this week to receive the 2000-01 Ohira Masayoshi Award for my book on Korea, which is titled Avoiding the Apocalypse: The Future of the Two Koreas.

Korea experienced a terrible financial crisis in 1997 and 1998. GDP growth swung from seven percent to negative seven percent in the following year, a 14-percentage point drop. As a consequence of this tremendous shock, Korea adopted a number of reforms and has consequently experienced quite a remarkable recovery. What are the lessons for Japan from Korea's experience in the last five years?

Japan's story is well known. But in my view, Japan faces four challenges. The first has to do with financial system. The second is deflation. The third is a fiscal problem. And the fourth deals with structural changes.

Regarding the first issue, most of the problems in the financial sector are in the banks. But the problems are not limited to the banks; there are problems in the insurance sector, for example. The volume of non-performing loans is enormous, perhaps $1 trillion. In the past decade, Japanese banks have made provisions for JPY60 trillion for bad loans. This figure is bigger than the annual GDP of South Korea or Canada, or Belgium and Holland combined.

Banks have made provisions for a huge amount of non-performing loans. But the bad loans continue to mount. There was recapitalization of the banks in 1999 and since then there has been unwillingness by the Financial Services Agency in particular and the political system more broadly to admit that that recapitalization did not solve the problem. Japan has wanted to shoot the messenger. When people outside of Japan have raised issues about Japan, they have often been attacked. It is counter productive for the Japanese government to attack the rating agencies, because it signals that Japan is in denial.

If Japan continues to deal with the NPLs simply with a provisioning strategy, it could take another decade to solve. Japanese banks, if you look at the rating agencies' analysis, exhibit the most extreme divergence between their intrinsic financial strength and the ratings strength. If you look at individual financial institutions in isolation, you see they get extremely low ratings from rating agencies. But they receive relatively high ratings because the rating agencies assume these institutions will not fail. There is an implicit government guarantee.

The second issue is deflation. Japan is the first industrialized country since the Great Depression to experience deflation. The Bank of Japan has been incompetent both in policy and in its public relations. Governor Hayami's statements have undermined market sentiment and have signaled to the rest of the world that Japan is in denial. The solution is inflation targeting. The problem is that Japan's myriad problems interact with one another. If you adopt that policy and generate positive inflation in Japan, you risk creating problems in the government bond market, and consequently in the banks.

The third area is fiscal policy. The Ministry of Finance bears responsibility for the fiscal problems and the opaqueness of the fiscal situation. Nowadays, the fiscal situation is not only bad on the books but the problem is that we really don't know what sort of contingent liabilities are off the books: the guarantees extended to third-sector projects, the implicit guarantees that would be extended to the prefectural and other local governments should they go belly up, implicit guarantees to a future bank recapitalization, and the implicit guarantees for pensions.

If you look at the government's fiscal situation using standard accounting, it looks bad. If you try to make a guess at what some of the possible contingent liabilities are, it looks horrible. There is no easy solution at this point of time. In the long run, Japan needs fiscal consolidation and reduction in spending, probably reneging some commitments, such as social welfare commitments. The problem is that doing those things in a short run is actually going to depress the domestic demands and actually is going to make things worse.

So the fiscal situation presents a conflict between long run and short run considerations. Much has been made on the fact that Japan's debt rating has now been downgraded to the level of Botswana, Czech Republic, and Israel. From of my experience, most Japanese people don't know where Botswana is. So, given most Japanese debt is held within Japan, being downgraded to the level of Botswana will not be that catastrophic.

If you simply take this credit rating chart, put together by Standrad & Poor's, you see that around December 31 of this year and January next year, Japan and South Korea will actually intersect. And starting in year 2003, Korean sovereign debts will be actually rated higher than the Japanese government' s sovereign debts. I figure having a rating below South Korea might be the thing that will awake the Japanese people. How did we end up with a prospect of Japanese sovereign rate being rated lower than South Korean sovereign debts especially considering the Korean financial crisis in 1997 and 1998? Well, South Korea has done pretty well since 1998. Are there any lessons for Japan from South Korean experience?

South Korea has some advantages over Japan. First of all, it is a poorer country. As you can see, South Korea took a real hit on GDP in 1998. The 14 percentage-point swing in its GDP growth rate in a country that does not have a very well developed social safety net would have a really strong reverberation in the political system. That is to say if you want a shock to the system, if you want to get a wake-up call, a 14 percentage-point swing in GDP growth is one way to do it.

Secondly, the South Koreans were lucky. They had a presidential election in 1997 and a new president took over in February 1998. The South Koreans changed their president essentially at the onset of the crisis. So, when Kim Dae Jung came in the office in February 1998, he was able to do two things. One, he could blame his predecessor for the crisis. Secondly, he didn't owe any of the constituency groups that helped them get into the crisis any favors. So, he had a much freer hand politically to design a new program to deal with the crisis. Also the South Korean Constitution gives the president far stronger political powers than the prime minister here in Japan has.

The third advantage that South Korea had is that it is relatively small compared to Japan. Japan has what I call "the curse of the large country." In the United States, it is possible to rise to great prominence and speak no language other than English. Americans are willfully ignorant of the world outside the United States, but can be quite successful. Japan is somewhat similar. Because Japan is large, it is possible within this society to do quite well with little exposure to the outside world.

South Koreans outscore Japanese in TOEFL scores. Both Japan and Korea do pretty badly compared to the rest of Asia. There are may be sample selection problems here. But the point is that South Koreans have more exposure to the outside world. Of those I meet with, a much higher percentage of South Korean economists have been trained outside South Korea. They are either trained in the United States, UK, or Germany. Many of them have worked for the World Bank and the IMF for some period of time before going back to South Korea.

Here in Japan, you have a situation where Todai only hires only Todai graduates and Kyodai hires only Kyodai graduates. So, it is not only insular on the national level, it is insular on the university level. I would argue South Koreans are more familiar with, and possibly more accepting of experiences, lessons, and advice from the outside. Smaller countries have to be pragmatic. Japan, like the United States, has the curse of being big.

South Korea has also been more aggressive in dealing with non-performing loans. There has been much greater use of asset-backed securities to get things off the banks' books. And more importantly, while Koreans set up a government organization to buy bad loans from banks, it has been much more successful at putting those assets back into the market. Korea has removed bad loans off the books so that banks get back their footing. But the other thing is that, instead of warehousing these assets, Korea has put the assets back into the market so that those assets get new management. Here in Japan, there has been a great tendency to warehouses the assets. The assets have to get into the market and be managed by the people who really want to manage them productively to get the economy going.

There is fiscal policy. Korea has had a tendency toward fiscal restrictiveness. The Korean fiscal situation has been historically dominated by a government bureaucracy that has had a tendency to have a tight budget. In Japan, politicians have taken that power away from the ministry and as a consequence Japan has experienced a rise in fiscal deficits over the last ten years, which are now running at six to seven percent of GDP. There has been a rapidly rising stock of gross financial liabilities in Japan. It probably is 115 percent of GDP. Japan's interest costs on that debt are extremely low because interest rates here in Japan are effectively zero. If you had some positive inflation in Japan, say 3 percent, the government would have to rollover all of the bonds. And the government will have to start paying real interest.

The bottom line is that Korea has experienced has much faster recovery. GDP growth in Korea this year is expected to be past seven percent and something over seven percent for the second half of the year. Japan seems to be coming out of the recession largely with the help of exports and public expenditures. The consequence may not be robust or sustainable growth.

Let me talk a little bit about trade issues. There has been talk on a free trade agreement between Japan and South Korea. But I am quite skeptical. I think in general, FTAs are not worthwhile. We will probably be better off putting energy into negotiating liberalization on a global level under the WTO. I am particularly skeptical about an FTA between Japan and South Korea or between Japan and China because all are now members of the WTO and according to the WTO rules, free trade agreements have to cover substantially all products. And the problem is agricultural trade liberalization.

My colleague Takatoshi Ito argues that by entering an FTA with a relatively liberalized country like Singapore, in many non-trade areas such as professional accreditation, the liberal country puts pressure on Japan to pursue reform. The fact that Japan got into a crazy argument over goldfish even with Singapore suggests to me that the lobbying of the Ministry of Agriculture, Forestry and Fisheries remains strong. As a consequence, I'm skeptical of Japan's ability to negotiate free trade agreements.

When I asked my Korean friends how would they plan to negotiate a free trade agreement with Japan, their response is that Japan is the only country in the world with an agricultural sector less efficient than Korea's. So Korea can negotiate a free trade agreement with Japan, but an FTA simply detracts from what I really think is important: trade liberalization negotiations on a global level in the Doha round. In the end FTA negotiations may even cause diplomatic problems with the ASEAN and the United States-entities that are important for the foreign policy of Japan.

The bottom line of my talk is that Japan is a strong society with weak economy. Economic policy lessons that Japan can learn from Korea, the United States, and other countries are relatively technocratic. It is a matter essentially of implementation or execution. That raises political issues but if the prime minister and the members of the Diet decide that they want to do something, it is fairly straightforward.

Conversely, Japan's relatively superior performance on a wide range of socioeconomic indicators is something that is more difficult duplicate in other countries: Life expectancy is highest in Japan. The number of babies born to mothers under 20 years old is very low in Japan. Infant mortality is low in Japan. Japan is slightly ahead of the US in tertiary education because Japanese males are ahead of American (non-white) males. Japanese mothers are mostly bearing live children. Incarceration in Japan is the lowest. US murder rates are several times those in Japan. The big exception here is anything related to gender; in gender issues, Japan looks like a third world country.

Japan is a strong society but a weak economy. Its economy has a variety of challenges. And unfortunately, a lot of time has been wasted. At this point, one cannot devise a solution to Japan's economic problems that will not involve significant amount of pain for a significant section of the population. But once those policies are undertaken, one can expect a fairly robust rebound of the Japanese economy. The real issue is how long this strong society can be maintained in a relatively weak economy.

Questions and Answers

Q: I would like to ask you about contingent liabilities. Japan's debt to revenue ratio keeps growing. What do you expect for Japan's economic growth, and thus its debt to GDP ratio? How far can the situation go?

I think the fundamental problem with Japan is the fiscal problem, which is absolutely crushing. I believe Japan can play it out for another several years. Ultimately the problem has to be addressed. How to do it? I think there have to be three components to solve the problem. First is inflation. You have to have a certain amount of inflation in the real value of existing debts. Second, there is going to have to be a reneging of social welfare commitments. There are huge deficiencies. And I think the health care delivery system for dealing with the elderly people is probably the number one place. Japan, relative to other countries, is very inefficient in that health care delivery. It is especially inefficient in the provision of care for the elderly. If you could get a really efficient system there, given the demographics that the elderly are going to take a bigger share of the population, this would reduce the government' s future expenditure. I believe that if you're going to solve the fiscal problem, it has to be the combination of the inflated value of the debts, reneging some of the commitments and efficiency gains, the third element. Default is not an option. The funds will have to come from social security. It is not a purely distributional issue. You need efficiency gains. Tax reform is good, but you need it to be revenue neutral. Tax cuts to households would reinforce structure changes in the economy; you could take away funds from the construction companies.

Q: Will Japan's risk premium go up?

This is the JPY64 trillion question. The problem is this. Many outside observers of Japan have looked at the situation and found it incredible. Japanese households are willing to hold Japanese government bonds with effectively no interest. One may ask, what is the alternative? You don't want to put money in non-yen assets because foreign exchange risks are high. Although it is strange from a non-Japanese standpoint looking at what people are doing, it is possibly understandable from the Japanese households' standpoint. This brings up the question why people keep buying JGBs, and not other yen-denominated assets. And I cannot give you a good answer. My colleague argues that reallocation is now underway in Japan, that you see the rise in gold market, you see the draining of commercial bank deposits, you see unwillingness of foreigners to continue to buy into this market. From this, he concludes that by September this year, there will be a financial crisis. At the end of the day, this comes down to Mrs. Watanabe. If she is willing to continue to put the household savings in the JGBs, the Japanese government will maintain its strength another several years.

Q: Can inflation targeting work in a deflationary environment?

There is some historical precedence. For example, in Sweden in the 1930s, they adopted inflationary targeting and managed to move the inflation rate from negative to positive. It seems to me that the problem of the Japanese monetary policy at this point is not whether inflation targeting is desirable or whether it would be effective. They have not even tried it. If you got inflation up, you risk provoking a crisis in the JGB market and thereby worsening the situation for banks. So, I would say that from the monetary standpoint, inflation targeting is preferable, although it is not a panacea.

The IMF's World Economic Outlook, which came out earlier this spring, devoted an entire chapter to the experiences of industrialized countries and their recessions. One of the big lessons is that if industrialized countries have significant structural problems, the countries that do not adopt reforms experience recurring recessions for a prolonged period of time. The economy may not collapse but rather it goes into recession then comes back for a few quarters then again goes back in. But when a country undertakes reforms, its economy comes back very strongly. Examples would include Switzerland in the 1970s, New Zealand in the 1980s, and the United States in the 1970s and 1980s. The situation for Japan is not hopeless. But without taking on certain issues it is hard to see the Japanese economy experience sustained robust growth.

*This summary was compiled by RIETI Editorial staff.