Miyakodayori 41

Macroeconomic policy for Japan's non-performing loans: Bad loan disposal and bond management

June 13, 2002

From a macroeconomic point of view, to dispose of bad loans is to reduce excessive private debt and convert it into government debt. Since the presence of bad assets within the private sector is causing inefficiencies in the entire economy, converting private sector debt into government debt will have a significant impact on the real economy, in addition to cleaning up the balance sheets of banks and firms.

Solving the bad loan problem is indispensable to the recovery of the Japanese economy. Yet inspections by the government based on stricter loan assessment criteria alone cannot solve the problem. It is important to create a macroeconomic environment that encourages business entities to accelerate bad loan disposal.

One option is to provide banks with opportunities to earn higher profits, thereby encouraging them to terminate loans to bad borrowers. For instance, higher long-term interest rates would create an environment in which banks can secure a certain amount of profits by purchasing long-term government bonds. Should this happen, the amount of outstanding loans to inefficient corporate borrowers would fall.

For this scheme to work, however, banks must be prevented from suffering appraisal losses brought by falling bond prices. Specifically, banks need to be able to book the value of government bonds based on acquisition cost under the condition of holding them until maturity. Another prerequisite is not to allow banks to continue "forbearance lending'' to nonviable borrowers, or rollovers of bad loans. To fulfill these conditions, the responsibility of banks' past management teams must be fully accounted for. Both shareholders and supervisory authorities must keep a careful eye on bank management to ensure that banks realize high profitability.

If long-term interest rates are kept high and banks accelerate bad loan disposal, more companies will go under, more people would lose jobs, and corporate liquidity crises will become more frequent. To cope with these situations, the government will have to implement fiscal measures and the Bank of Japan pump more money into the call market.

So if the government is to help banks earn profits in the form of higher interest rates on government bonds held by the banks, at the same time, it would have to increase fiscal expenditures to tackle unemployment, help rehabilitate small and midsize companies, and alleviate other shocks caused by the bad loan disposal. Should the government inject public funds into banks, it would be another form of fiscal expenditure.

Therefore, in the process of reducing the banking sector's bad loans and re-stabilizing the private sector economy, government debt will inevitably increase. This means private sector debt will be transferred to the government. Once the bad loan problem of the private sector settles, the real economy will gradually regain strength and return to a path of sustainable growth. It then becomes a question of how to manage a soft landing of the public debt problem.

Concerted efforts by all concerned government agencies are vital to realize a combination of two policies: transferring excessive private sector debt to the government (bad loan disposal), and reducing government debt over a long period of time (government bond management policy).

First, the Financial Services Agency should maintain strict administrative inspections and urge banks to quicken their disposal of bad loans while looking into their management responsibility. Setting improved bank profitability as its policy goal, the FSA should reform the financial system and reinforce supervision over bank management. Meanwhile, it should allow banks to use acquisition costs to book the value of their hold-to-maturity government bonds, granting the opportunity for banks to improve profitability.

Second, the Ministry of Finance should diversify the timing of government bond maturity and ensure market stability. To maintain confidence in fiscal discipline, the Ministry should revive the Fiscal Structural Reform Law with an amendment to add an elastic clause to counter cyclical fluctuations, and present a long-term vision for fiscal reform. At the same time, the Ministry should tolerate a temporary expansion of fiscal expenditures to prop up overall demand and facilitate structural reform, taking necessary measures to cope with increasing unemployment and bankruptcies, an unavoidable result of bad loan disposal.

Third, the Bank of Japan should keep short-term interest rates at or near zero and guide long-term interest rates upward to stabilize at a relatively high level, thus better facilitating banks' bad loan disposal. To cope with the liquidity crises of corporate borrowers, the central bank must be agile and flexible in boosting short-term money supply to prop up overall demand. Once the private sector economy is back on its feet, the BOJ should embark on price-support buying of government bonds, guide long-term interest rates lower and prevent a plunge in government bond prices.

Fourth, it has been noted that the virtual disrespect of debt claim priority in bankruptcy cases explains banks' inefficient lending activities, such as forbearance lending to nonviable borrowers and unnecessary credit squeezes on small- and midsize companies. The judicial authorities should reform bankruptcy proceedings to enable quick and efficient corporate reorganization and prevent inefficient lending activities by banks. This would help reduce excessive private sector debts and minimize financial burden on taxpayers.

Finally, government agencies should facilitate companies' entry to and exit from the market by promoting deregulation and reinforcing competition policies. They should also help the formation of potential growth industries, such as information technology, financial engineering, and biotechnology, etc., by providing support for technological development. With bad loan disposal in the private sector on course, the real economy should regain strength and long-awaited sustainable recovery should arrive. This growth will also help reduce public debt. Moreover, appropriate monetary policies amid massive outstanding government bonds could induce modest inflation, effectively reducing the government's burden of debt repayment.

Author, Keiichiro Kobayashi
Fellow
Research Institute of Economy, Trade and Industry (RIETI)

Editor-in-Chief, Ichiro Araki
Director of Research
Research Institute of Economy, Trade and Industry (RIETI)
e-mail: araki-ichiro@rieti.go.jp
tel: 03-3501-8248 fax: 03-3501-8416

RIETI invites you to visit its English website
[http://www.rieti.go.jp/en/index.html].

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).

June 13, 2002