Miyakodayori 14

Debt Disorganization ---Part 2: Policies and Scenarios

This essay is based on Keiichiro Kobayashi's article, "Crash or Revival: Trap of the Japanese Economy" which appeared (in Japanese) in the April edition of the magazine Bungei Shunju.

Our "Debt Disorganization" story implies that we need to resolve the bad debt problem (banks' non-performing loans and excessive corporate debt) first in order to achieve economic recovery. Then what are the strategies and scenarios for the resolution of the bad debt problem?

There are basically four possible strategies to solve the problem:

Strategy 1: The grow-out policy (the Fabian policy)
Strategy 2: Managed inflation
Strategy 3: Bank Holiday (compulsory disposal of NPL)
Strategy 4: Coordinated debt restructuring

Let us examine them one by one. Strategy 4 is my recommendation.

STRATEGY 1: THE GROW-OUT POLICY

1. Strategy
This strategy is to simply hope that banks dispose of non-performing loans (NPLs) voluntarily, while the government and the central bank support aggregate demand by Keynesian policy and capital injection to the banking sector. This is basically what we have done for years.
Every year banks, which do not want to be bankrupt or nationalized, dispose of very small amounts of their outstanding NPLs, which can be completely covered by their annual profits. This is because banks would be bankrupt if they disposed of all amounts of their NPLs at once.
Under this strategy, the total amount of NPLs should be decreasing gradually. While the Japanese economy buys time with this strategy, unexpected surprises such as the IT revolution or structural changes in industry make the Japanese economy stronger, and it might, it is hoped, outgrow the debt problem. This is the scenario what we have expected.

2. Scenario
However, if debt disorganization causes stagnation, this strategy does not work. If significant amounts of NPLs remain, the real amount increases due to debt disorganization caused by the remaining NPLs. Thus, NPLs do not decrease, but actually increase through voluntary and gradual disposal.
If we continue this grow-out policy, the Japanese economy will continue to stagnate and the balance sheet of the government (including the central bank) deteriorates with increasing speed, as we continue fiscal and monetary expansions. The final destination is capital flight and bankruptcy of the whole economy, as happened in Latin American countries in the 1980s, or in Indonesia and Russia in 1998.

STRATEGY 2: MANAGED INFLATION

1. Strategy
This strategy is for the Bank of Japan (BOJ) to maintain gradual and stable inflation at three percent a year for a long period (for example, 15 years) through monetary easing. The aim of this strategy is to decrease the corporate debt and the public debt in real terms through inflation, and have inflation stimulate spending (consumption and investment) which helps the economy to recover.

2. Scenario
The manageability of inflation is quite doubtful. The public debt of Japan is 130 percent of its GDP. This is equivalent to that of the public debt of Japan right after the World War Two. Right after the war, Japan suffered hyperinflation in which prices rose 60,000% in 10 years. We have too much liquidity already. If inflation begins in this situation, there is a high probability that the Bank of Japan will lose control.
By the way, the reason why Japan suffers deflation now is not the shortage of base money, which is supplied by the BOJ, but the shrinkage of money supply (M2) caused by the malfunction of banking activities. The contraction of the financial intermediary is partly due to the bad debt problem. Thus, it seems to me that the direct remedy for today's deflation is the resolution of the NPL problem, not monetary expansion by the BOJ.
Even if inflation is successfully managed, the future of the Japanese economy is not very bright. It will suffer debt disorganization as long as a significant amount of NPLs remain (for 15 years or even 30 years). During this process, the stagnation due to debt disorganization continues, and the inflation gradually devalues the wealth of the nation. Living standards will become significantly lower when this strategy runs its course.

STRATEGY 3: "BANK HOLIDAY" (COMPULSORY DISPOSAL OF NPLS)

1. Strategy
The most direct method to dispose of NPLs is a "bank holiday", which was implemented by President F. D. Roosevelt in March 1933. The U.S. government inspected all banks very rigorously in a week and decided very quickly to close 5500 banks. All NPLs were disposed of and the loss shared by bank shareholders, general creditors of banks, and depositors. In cases where the loss was too big, taxpayer money was injected as preferred stock to banks. The management of failed banks took the blame by resignation and restitution. Almost all the taxpayer money injected into the banking sector ($ 1.2 billion) was recovered in 25 years.

2. Scenario
This "bank holiday" scenario is not likely to happen in today's Japan. First, the sense of crisis is lacking. In 1933, the central bank of the U.S. was bankrupt and 13 million people were unemployed. Compared to the Great Depression, today's Japan is not in critical condition in real terms. Second, political leadership is lacking. Even if we implement the "bank holiday" strategy, this policy may not be sufficient for debt disorganization, because suspicion between corporations must be removed and there must be a recovery in confidence to break out of "low equilibrium." We need to take action on distressed debtors (corporations), not only on banks.

STRATEGY 4: COORDINATED DEBT RESTRUCTURING

1. Strategy

In the present scheme of bank regulation, all the Financial Services Agency of Japan does is inspect banks and to urge them to dispose of NPLs by themselves. The FSA does not take compulsory measures such as a "bank holiday," which requires political leadership. However, even in this situation, the FSA can do something more than what they do today. The FSA can apply more rigorous standards for bank inspections and smoke out hidden NPLs. Then, banks will be forced to actually dispose of remaining NPLs. In this case, the capital accounts of banks will be significantly damaged. It will be necessary to inject significant amounts of public money into the banking sector yet again. Last time (March 1999), the public money was injected in exchange for preferred stocks WITHOUT voting rights, while bank managers and existing bank-shareholders were not punished at all. Next time, we need more fairness in the usage of public money.
In the meantime, we need to formulate systematic policy for debtors of NPLs. The practice of bankruptcy procedures, especially reorganization procedures, must be reformed to speed up debtor restructuring. The Resolution and Collection Corporation (RCC, the Japanese RTC) should be reformed so that it can rationally manage and develop real estate that the RCC obtains as collateral. (In the current situation, the RCC is not allowed to manage and develop the real assets. It has no other choice than to sell off the collateral at a heavy discount.) Since corporate finance in Japan is malfunctioning, we need to reform the commercial code and tax practices to utilize new financial techniques like DIP finance, debt-equity swaps and mezzanine finance. These new techniques are not utilized in Japan because of the old-fashioned commercial code or corporate regulations. Such regulations should be reformed to utilize these methods for corporate restructuring.

It may be useful if the government coordinates the establishment of an investment fund that collects money from investors in the private sector, pools the NPLs of various companies and implements those firms' reorganization and restructuring. The Law of Large Numbers would work in this case to enable the fund (and its investors) to manage corporate risks appropriately.

2. Scenario
If the NPLs in banks' balance sheets are disposed of and heavily indebted companies are reorganized systematically through this strategy, the Japanese economy can get out of the trap of debt disorganization. Public policies for unemployment and other demand side policies might be necessitated to mitigate short-term deflationary pressure from the debt restructuring process. In the short-term, the position of the government's balance sheet will deteriorate, but the state of public finances will improve gradually in the long-term as the economy gets out of debt disorganization.

REMAINING PROBLEMS

On March 15th, the idea of a publicly supported stock-pooling fund surfaced. The fund is supposed to buy corporate stocks from banks that owned huge amounts of corporate stocks as their assets, while the potential future losses of the fund due to stock price volatility is supposed to be covered by taxpayer money.
In the meantime, the FSA strongly urges banks to dispose of the NPLs, but it decisively denies the need for additional injection of public money to banks' capital accounts.
In this situation, there are remaining problems that should be addressed properly.

1. Need for debtors' restructuring
The fund plan of March 15th aims only to clean up banks' balance sheets. It has no plan to deal with debtors. If this fund can take decisive actions to restructure and reorganize debtor firms, it will be an effective policy on debt disorganization. The current plan has nothing to do with restructuring debtor firms, and the loss is covered by taxpayer money. Therefore, we cannot help seeing this fund plan as a stock price-support policy or forbearance policy. Such a fund will surely be effective in reducing banks' exposure to stock price volatility. But the policy will become truly meaningful only if it makes clear how debtors' restructuring should proceed. And the use of taxpayer money to cover the funds' potential losses in a policy that does not have this broader goal is unacceptable. Otherwise, the banks that sold the stocks to the fund need to take the blame for any losses. Taxpayer money should be used only toward the long-term stabilization of the financial system, not for stock price support.

Injection of public money to bank capital
The size of NPLs is not accurately known and many people in the financial community say that it is inevitable to inject a significant amount of additional taxpayer money if banks are to dispose of all the remaining NPLs. On the other hand, banks (and bank regulators) officially assert that they do have enough capital, for political reasons.
To face the facts squarely, we need the accurate disclosure of the real size of NPLs and to clean up bank balance sheets without hesitating to use public money if necessary.

See our working paper: Kobayashi, K. and M. Inaba, 2000, "Disorganization due to Forbearance of Debt Restructuring" for details of the theory and empirical results. http://www.rieti.go.jp/jp/publications/dp/downloadfiles/m4235-2.pdf [PDF:271KB]

Author, Keiichiro Kobayashi, Ph.D.
Special Research Fellow, Research Institute of Economy, Trade and Industry, M.E.T.I.
e-mail: kobayashi-keiichiro@rieti.go.jp
tel: 03-3501-1480 fax: 03-3501-1704

Editor in Chief, Nobuo Tanaka
Executive Director, Research Institute of Economy, Trade and Industry, M.E.T.I.
e-mail: tanaka-nobuo@rieti.go.jp
tel: 03-3501-1362 fax: 03-3501-8391

The opinions expressed or implied in this paper are solely those of the author, and do not necessarily represent the views of the Ministry of Economy, Trade and Industry (METI), or of the Research Institute of Economy, Trade and Industry (RIETI).

March 19, 2001