On April 6th, a new economic policy package was announced by the Japanese government. I would like to share my personal assessment of the package with the readers of the Miyakodayori.
The package recognizes the importance of resolving both the non-performing loans (NPLs) of the financial sector and the excessive debt of the corporate sector. It should be noted that it is probably the first time that the resolution of the NPL issue dominated the economic policy package, and I believe that this reflects the recognition by the government and coalition parties that we cannot grow out of our problems. We need to resolve the NPL problem before we can expect to have sustained economic growth.
It should also be noted that the package is the first official attempt to deal with the other side of the coin of the NPLs, which is the excessive debt of the corporate sector. This is probably the most important significance of the package. The previous policies have basically focused on the financial side only. But putting up provisions for loan losses in bank balance sheets will not alter the financial condition of the borrowers, and can lead to the further deterioration of their assets and businesses. This would result in the deterioration of the value of the loans to such companies. This is why resolution of NPLs and corporate debt are now seen as closely intertwined.
Based on this recognition, the package stresses the need to write off NPLs, not just putting up reserves, and to engage in the restructuring of the debts of the borrowers. I believe that this is a major positive step.
The package includes many measures to improve the environment to restructure debts. The package means that tax treatment of debt forgiveness will be more transparent. Debt-for-equity swaps will be made easier through deregulation. Codes of conduct for the banks in the process of debt restructuring outside of courts will be established based on the model of the so-called "London Approach," initiated by the Bank of England. Regulations will be changed to facilitate DIP finance to provide the necessary funds to the firms under reconstruction. Corporate reorganization procedures would be further revised to make our procedures much closer to the U.S. Chapter 11 procedures. Banks would not be penalized for falling short of their profit targets, committed to when they received the injection of public money, if the losses are the result of proactive NPL write-offs. These measures are very helpful for banks and companies when they engage in debt restructuring, and the announcement of these measures is another positive and important step.
But these measures are the "tools" to enable debt restructuring; there must be a decision to actually start the debt restructuring. In this regard, the FSA's emphasis on writing off NPLs is very meaningful. The FSA would set a time frame of a two to three years to force the major banks to write off the NPLs classified roughly as category 3, or "doubtful." Such a time frame would ensure that debt restructuring would actually take place.
However, the scope of NPLs falling under such a time frame is very narrow. The total value of the NPLs classified as category 3 is significantly smaller than the value of the loans classified as category 2, or "sub-standard" in the U.S. Many analysts suspect that substantial amounts of NPLs remain in category 2 or possibly even in category 1, which are termed "normal." They argue that the full recognition of the potential losses associated with such "hidden" NPLs is necessary, and if it leads to the erosion of the capital base of the banks, then public capital should be injected, with attendant restructuring of the banks. In my personal view, I would have to agree with them. The experience of the past several years, having observed the failure of many companies with huge debts, should give the benefit of the doubt to the pessimists (or the "realists").
This is exactly the area in which I hope to see additional steps. Stricter asset classification and broader write-offs are essential. If these actions result in the shortage of capital, capital injection should be undertaken without hesitation.
Having said this, I would like to stress that the current situation is different from the fall of 1998, when it appeared that we were heading into a crisis. A number of foreign journalists and investors tend to describe the current situation as a crisis, but I believe that it is important to distinguish a crisis from a problem. Yes, we do have a problem. However, compared with a few years ago, progress has been made. A 70-trillion-yen safety net to protect the financial system is now put into place. Also, 25 trillion yen of NPLs have been written off or have had reserves placed against them. Three of the weakest major banks have already collapsed. The stock market is still about 20% higher than the bottom in the fall of 1998. (Remember, the Nikkei index was changed in April 2000 so that the current Nikkei average cannot be compared simply with the Nikkei average which went as low as ¥12880 a few years ago.) What is important is to face the problem and deal with it without panic. I am encouraged by the fact that we are finally recognizing the problem and taking the necessary steps to deal with it. What remains is to take the necessary steps far enough to see the resolution through.
Another pillar of the package is the scheme to buy up stocks held by the banks as a part of their cross-shareholding. The package requires banks to limit their stock ownership to a certain level to minimize the banks' exposure to stock market fluctuation. To provide a shock absorber for the unwinding of cross-shareholdings, the package proposes the establishment of an organization to buy up stocks owned by the banks. The purchased stocks would basically be frozen in the organization for five years. After the five-year period, the stocks would be released to the market or bought back by the issuing companies.
The funds to buy the stocks would basically be provided by the selling banks. The government, according to the original plan of the coalition parties, would provide a guarantee for such loans. As a result, if the organization incurs losses after five years, those losses would be assumed by the government, so there is no downside risk for the banks. On the other hand, the banks would enjoy the upside if there is appreciation in the stock price, through their ownership in the organization. The objective of the scheme is understandable. The unwinding of the cross-shareholding to isolate banks from market volatility makes sense. This scheme would also have the short-term effect of raising the prices of banking sector stocks by removing some of the risk. However, critics have raised several questions with regard to the means to achieve such an objective. They also question the mid- and long-term effect of the scheme on the stock market.
First, why should taxpayers pay for secondary losses at the end of the five-year period? If the reason is to protect the financial system, why not utilize the capital injection scheme already in place when necessary? The secondary losses would then be assumed initially by the banks. Capital injection would be allowed only when capital erosion is serious enough to warrant it. In contrast, the proposed plan would have the taxpayers assume the losses even if there is sufficient capital for the banks.
Second, why do the banks enjoy the upside without being exposed to the downside?
Third, if the banks were allowed to decide which stocks to sell to the organization, wouldn't they sell the "lemons"? If that were the case, wouldn't the probability of secondary losses be larger? Fourth, wouldn't the freezing of the stocks in the organization for five years delay the improvement of corporate governance, improvement which has been greatly anticipated as the result of the unwinding of cross-shareholdings? Wouldn't this delay become an impediment for rapid structural reform of the Japanese corporate sector?
Fifth, would keeping stocks, the value of which may amount to 10 trillion yen in total, out of the market for a while with the expectation that they would be returned to the market after five years, depress the prices of the stocks during the period?
These are some of the questions that need to be answered, or at least considered, before the actual implementation of the plan. The new prime minister will have to think about these questions. The Diet, when it considers the bill for establishment of the stock-buying organization, will also have to review these questions. Such considerations would certainly have an influence on the scheme's concrete design.
Public opinion and market reaction will have a major impact on considerations by the new prime minister and the Diet. We need to keep a close eye on developments.
I hope that this memo has helped readers to understand and evaluate the economic package. To sum up, the package does include significant and positive steps. However, it is hoped that more will be done, building upon the achievements in this package, with regard to the full recognition of potential losses associated with the NPLs and the injection of capital when necessary. Questions concerning the stock-buy-up organization need to be considered, and answered.
Author, Tatsuya Terazawa
Special Research Fellow, RIETI, M.E.T.I.
e-mail: terazawa-tatsuya@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.
Research Institute of Economy, Trade and Industry, IAI
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).
