Concerted Policy Efforts Necessary to Solve Bad Loan Problem - Macroeconomic Environment to Facilitate Banks' Efforts
From a macroeconomic point of view, disposing of bad loans would reduce excessive debt in the private sector by transferring it to the government. Stabilizing long-term interest rates at a relatively high level would also improve the business environment for banks, giving them greater incentive to accelerate their disposal of bad loans. This should be followed by the formulation of a policy package to reduce government debt over a long period of time, emulating the postwar government debt management policy of the United States.
Keep long-term interest rates high
Discussions from various microeconomic viewpoints have been held on the disposal of bad loans. One major argument calls for adopting a strict asset valuation method based on market values and appropriate write-offs. Another says that simply setting aside more money for a loan loss reserve fund is not enough. Instead, it says, banks should completely remove bad loans from their balance sheets through the liquidation or rehabilitation of debtor companies so as to restructure real economy.
A newly emerging view, meanwhile, points out that the virtual disrespect of debt claim priority in case of bankruptcy is the reason behind banks' ineffective corporate financing activities such as lending to troubled corporate borrowers for the sake of collecting otherwise uncollectible interests on earlier loans and unnecessarily refusing loans to small firms.
If all the problems are cleared and adequate measures for bad loan disposal are implemented, then structural reform will proceed and long-lasting, sustainable economic growth will be achieved.
There is no over-emphasizing the microeconomic aspects of the bad loan problem. In this article, however, I would like to take a different approach, examining the problem from a macroeconomic viewpoint. (The following is strictly the author's personal view.)
From the macroeconomic point of view, to dispose of bad loans is to reduce the excessive debt accumulated in the private sector and convert it into government debt. (Because the dispersed presence of soured assets within the private sector is causing the inefficiency of the entire economy, converting private sector debt into government debt can have a meaningful impact on real economy in addition to cleaning up the balance sheets of banks and firms.) However, such a scheme must be accompanied by a rebuilding of troubled debtor companies; thus, it cannot be carried out in a year or two. A considerable period of time must be given.
Clearly, solving the bad loan problem is indispensable to putting the nation's economy on the long-term recovery path. Yet we cannot expect that inspection by the government based on stricter loan assessment criteria alone can solve the problem. It is important to create a macroeconomic environment that encourages business entities to accelerate bad loan disposal. One policy option to achieve this end is to provide banks with opportunities to earn high profits, thereby prompting their own judgment to terminate loans to ineffective corporate borrowers.
For instance, if we could stabilize long-term interest rates at a relatively high level, it 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 succeed, however, we must prevent banks from suffering appraisal losses brought by falling prices of government bonds. Specifically, we need to allow banks 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.
Then, if long-term interest rates are kept high and banks accelerate bad loan disposal, it is anticipated that more companies will go under, more people lose jobs and corporate liquidity crises occur more frequently. 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.
Thus, 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 will 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 (excessive liabilities held by companies) and re-stabilizing private sector economy, government debt will inevitably increase. In terms of macroeconomy, this means private sector debt will be transferred to the government.
Once the bad loan problem of the private sector settles, it is expected that real economy will gradually regain strength and return to a path of sustainable growth. Then, the next question will be how to manage the soft landing of the public debt problem. In this regard, we can take lessons from the postwar government debt management policy in the United States. The U.S. government' s debts, which reached a level equivalent to 120 percent of the nation's gross domestic product immediately after World War II, were reduced to 40 percent of GDP over a period of 25 years.
Long-term approach in implementing government debt management policy
With massive government bonds outstanding amid growing fund demands from the private sector in the postwar period, fear arose of a sudden plunge of government bond prices that would incur huge capital losses for banks holding government bonds and throw the entire U.S. economy into panic. To prevent this, the Federal Reserve purchased government bonds on the open market to support prices, while the Treasury Department implemented a management scheme for bond maturity and redemption schedules as a counter-cyclical economic policy.
Consequently, the postwar U.S. economy suffered from chronic inflation caused by the presence of a massive government bond market. This long-term inflation, however, should be considered the necessary cost the U.S. had to pay to avert an otherwise inevitable plunge in bond prices and subsequent economic chaos. We can draw a lot much on the U.S. experience when we devise a long-term bond management scheme for Japan.
With bad loan disposal in the private sector on course, real economy should regain strength and long-awaited sustainable recovery arrive. And this will help reduce public debt. Also, appropriate monetary policies amid massive outstanding government bonds could induce modest inflation, effectively reducing the government's burden of debt repayment.
The fiscal theory of price level (FTPL) developed by University of Chicago Professor John H. Cochrane and others argues that when government bonds are outstanding on a massive scale, the price level goes up to restore the equation between the government's bond redemption burden and the present discounted value of future government tax revenues.
Based on the FTPL, the realization of modest inflation depends primarily on government bond management policies (bond maturity management by the Ministry of Finance, supply and demand adjustment of government bonds by the Bank of Japan, etc.).
For the moment, demand for funds in the private sector remains weak. Thus, private banks would continue to purchase government bonds even if their ratings were further lowered, thereby maintaining the stability of the market without support buying by the central bank. Given such circumstances, it would be advisable for the monetary authorities to guide long-term interest rates higher to enable private banks to secure high-profit opportunities. During the Great Depression, U.S. banks were able to secure earning opportunities by investing in government bonds. (Government bonds accounted for 60 percent of U.S. banks' total assets in 1945, sharply increasing from some 10 percent in 1930.)
All concerned government agencies should cooperate
Concerted efforts by all the concerned government agencies and other policymaking bodies are vital to realize this combination of policies; that, is transferring excessive private sector debt to the government (bad loan disposal), then reducing government debt over a long period of time (government bond management policy).
[Financial Services Agency]
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. (It is worthwhile considering ways to offer certain incentives; for instance, incrementally providing preferential measures in accounting in accordance with progress in bad loan disposal.)
[Ministry of Finance]
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 the 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.
[Bank of Japan]
Through supply-and-demand adjustment of government bonds, the BOJ 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. Then, 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.
[Courts and other judicial authorities]
It has been pointed out that the virtual disrespect of debt claim priority in case of bankruptcy is one reason behind 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 liquidation procedures to enable quick and efficient corporate rehabilitation and prevent inefficient lending activities by banks. This would help reduce excessive private sector debts (prior to their transfer to the government) and minimize financial burden on taxpayers.
[Other government economic agencies]
Other government economic agencies should facilitate companies' entry to and exit from the market by promoting deregulation and reinforcing competitive policies. They should also help the formation of potential growth industries (information technology, financial engineering, biotechnology, etc.) by providing support for technological development.
Born in 1966, PhD in Economics from the University of Chicago
* Article from NIKKEI Shimbun on April 15, 2002
April 15, 2002 Nikkei Shimbun
April 15, 2002
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