Recovery From Recession May Take Decades

Fellow, RIETI

Progress is being made in disposing of the piles of bad loans that have been clogging up the Japanese economy. Evidence of this was seen, for example, in the collapse of general contractor Sato Kogyo on March 3 after creditors decided not to extend the ailing firm further financing. The market was apparently pleased with this development; the next day the Nikkei average of 225 shares on the Tokyo Stock Exchange jumped 600 points. And some commentators are saying that the short-term economic cycle is bottoming out and we are about to see an upturn.
At the same time, however, the feeling is spreading that the economy is slowly sinking as deflation marches on. Support for the administration of Prime Minister Koizumi Jun'ichiro is wavering. Media debate on economic policy has once again fallen into the trap of thinking that the only alternatives are to put a stop to deflation or to dispose of the banks' bad loans. There is also a perceptible tendency for people to latch onto strange policies proposed as panaceas for the country's economy problems. An economic upturn such as we are seeing at present is the moment of truth for pushing ahead with structural reform. But as things are going, there is considerable danger of a relapse into the "anything goes" approach of earlier efforts to fight the recession. If that happens the country is liable to head down the road to long-term economic ruin.


What strategies might be adopted to deal with the situation? One approach is that of a protracted struggle to maintain the status quo. This strategy consists of continuing to prop up the economy with fiscal stimulus and monetary policy relaxation and having banks write off their huge portfolios of bad loans gradually within the limits of their profits year by year without forcing either banks or business corporations to go under. Whether one favors it or opposes it, however, this status quo strategy has become unsustainable.
One reason is the dire state of public finances. Total public debt, counting that of both the central government and local governments, amounts to JPY700 trillion. Moody's and other agencies have lowered Japan's sovereign credit ratings, and fears of a government financial collapse are growing by the day. It is not possible to expand the usual sort of fiscal stimulus (public works and tax cuts) further without any view of the prospects for servicing the ballooning debt.
The second problem is that the banks' reserves of spare capital are drying up. They have already used up virtually all of it, including their unrealized gains on shareholdings, the injections of public funds they have received in the past, and the gains realized from mergers, on the bad-loan disposals carried out so far. It is not enough for them to continue disposing of nonperforming assets within the limits permitted by their annual profits while waiting for the economy to recover.
Given this impasse, there is a growing temptation to resort to a strategy of inflation targeting as a means of solving the country's economic problems at a stroke. This strategy would consist in having the Bank of Japan bring about mild inflation by increasing the money supply. If a gentle increase in prices could be induced, economic activity would be stimulated; also, the real value of existing debts would be reduced, thereby lessening the load both of the bad loans in the private sector and of the public debt. In other words, there is a possibility that all the ills of the Japanese economy could be resolved in one fell swoop. Of course, since inflation would reduce the value of financial assets, this would in reality be a major transfer of assets from creditors (people with savings deposits) to debtors (the government and business corporations). In effective terms this would amount to the imposition of a wealth tax on depositors.
In an article I wrote for Bungei Shunju last year, I emphasized the negative aspects of this approach, noting that it was not certain that inflation could be controlled and that inflation would cause the value of people's financial assets to decline, effectively acting as a tax hike. If these negative effects are major, a policy of inflation targeting might cause as much hardship in people's lives as an economic collapse.
Since last autumn, amidst the continuing lack of improvement in the economy, the tone of economic commentary in the media has increasingly turned against structural reform toward support for inflation targeting as the solution. But those voicing this position still have not clarified whether inflation could actually be held within the target range or how much of a negative impact there would be if it were to get out of control. The argument appears to be along the lines of "It's better to go out with guns blazing than just sit around waiting to die."
Another idea one comes across, which starts from the premise that fighting deflation and disposing of bad loans are mutually exclusive alternatives, holds that deflation should be tackled first and the bad loans dealt with later. The basis for this idea is that ongoing deflation puts a squeeze on corporate earnings, causing yet more loans to become irrecoverable; steps should therefore be taken to eliminate deflation first, as the root cause of the bad loans. It may be that deflation is giving rise to some bad loans. But deflation itself is not occurring without cause. Worries about the bad-loan situation are putting dampers on both consumption and investment. And when goods do not sell, prices come down-in other words, deflation sets in. So the opposite causal relationship also exists: Bad loans result in deflation.
Recently some commentators have been going so far as to assert that all the existing bad loans have been caused by deflation. While it may be true that deflation gives rise to some new bad loans, to say that it is the cause of all existing ones is going too far. To claim, for example, that the collapse of firms like Mycal, Aoki Corporation, or Sato Kogyo and the crises at Daiei and Daikyo were caused by deflation is to insult the public's intelligence. These companies' woes did not result from deflation but from mistaken management decisions involving excessive real estate investments.
Deflation refers to a downward trend in general prices, not land prices. If land prices had risen rather than fallen, Aoki Corporation and Sato Kogyo might have been saved. But what this hypothetical scenario represents is not the end of deflation but a return of the land-price bubble. The repeated use of public funds in the 1990s to buy shares in order to prop up prices on the stock market was ultimately unable to produce a sustained rise in share prices, and as exemplified by this failure, unfortunately no policy tool has yet been discovered that can artificially sustain a speculative bubble.
A third strategy option is that of implementing the compulsory disposal of bad loans through the calling of a bank holiday. The fact that the bad-loan saga goes on and on has been producing a rising tide of public frustration. This has led to suggestions that the government should follow the precedents set by the United States at the time of the Great Depression and by Japan just after World War II, invoking the state's authority to stop the operations of all banks for a limited period in order to dispose of their nonperforming assets at one stroke. Some writers have been insisting that Japan must even repeat the postwar freeze on existing bank deposits, under which new accounts were segregated from old ones.
Such a strategy, however, must be considered extremely risky, since the political, economic, and social consequences are uncertain. The settlement of intercompany transactions is today part of a global mesh, and it is impossible to predict the repercussions on the Japanese and world economies if the business operations of all Japan's main financial institutions were temporarily suspended. I believe this strategy would be impossible to implement unless the preparations (involving also various foreign governments and international organizations) could be carried out very systematically, with great precision, and in secret.
Then there is a fourth option, namely a strategy of proceeding with the disposal of bad loans in a swift and rational manner utilizing such market mechanisms as the sale of nonperforming credits and the rehabilitation of troubled corporations through takeovers. In its general direction, the Japanese government's current policy aims at a balance between this strategy and measures to fight deflation through monetary relaxation. Many people, however, have their doubts about this policy stance, suspecting that the authorities' commitment to bad-loan disposal is liable to waver if economic conditions worsen. The process could then come to a halt and be replaced by a resumption of "anything goes" economic stimulus. And because of the widespread loss of faith in government policy, people are no longer willing to wait for the promised results; they want to see the results immediately.


Even if the general direction of policy is correct, there is doubt about whether it will be sustained. The sense of economic impasse is growing stronger. Why is this? Because confidence in the future of the economy has been decisively shattered.
Through the 1980s, when the Japanese economy was on a course of rapid growth, the overall framework of social and economic policy was stable, and public confidence in the future was sustained. The main-bank system was in good working order, and even when a company collapsed, its main bank or banks would take on the job of reorganizing and rehabilitating it. The main banks took the leading role in clearing up failed companies' debts in a flexible manner, fitting their methods to the circumstances of the firms and their creditors. The vagueness of this setup, under which matters were handled without going public, made it possible to deal with problem situations in a flexible and highly effective manner.
However, the volume of loans that went sour after the economic bubble burst in the early 1990s was beyond the banks' capacity to handle. The banks' strength was so depleted that the main-bank system could no longer be maintained. In other words, how to deal with corporate failures in the absence of main banks became a major task for the Japanese economy from the 1990s onward. It became necessary to create a replacement mechanism for disposing of bad loans. In fact, however, no such mechanism has been created, and the disposal of bad loans is making very slow progress. It is often said that the problem of bad loans is a matter to be worked out by the banks and the borrowers. But the crux of the problem is the fact that no viable new mechanism has been created to take over the role of the main-bank system. The creation of such a mechanism is not something that will make headway if left to the initiative of the parties concerned.
Because the bad-loan problem has been allowed to drag on without resolution, Japan has not developed any new consensus on the handling of corporate insolvency. The lack of such a consensus is the main factor behind the collapse of public confidence in the future. Under such conditions the entrepreneurial spirit atrophies, and companies shy away from any new undertaking that has even a hint of risk about it. As a result the economy as a whole becomes gloomy, and both consumption and corporate investment contract.
So what can be done about this? We have to come up with a reliable new set of rules for dealing with corporate failures. This is easier said than done, of course, and just talking about a new set of rules will not reestablish public confidence. The only way to restore confidence is by demonstrating the new rules in practice.
Here I would like to compare the experiences of Chile and Mexico in the 1980s. In the debt crisis of the early 1980s, both Chile and Mexico faced the collapse of their banking systems. Both countries first nationalized their banks, and then reprivatized them. There was, however, a major difference in the way they went about this. Chile carried the process out swiftly within just a year or two, using a vast amount of public funds equivalent to 30% of its gross domestic product, and dealt with the bankruptcies of the debtor corporations speedily. One reason why the process was so smooth was that the reform of the country's bankruptcy legislation was completed in 1982, and bankruptcy proceedings were thus handled with great efficiency. Mexico, by contrast, attempted to dispose of its banks' bad loans gradually.
Moreover, because its bankruptcy legislation was inefficient, dating back to 1943, the bankruptcy proceedings made very slow progress. As a result, although Mexico had the edge over Chile in terms of its trading environment and fiscal and monetary policy, Chile achieved much better long-term economic performance than Mexico, sustaining a high growth rate over the next two decades.
This example teaches the very clear lesson that, even when two countries' macroeconomic environments are similar, the country that is quicker at fixing its banking system and disposing of failed companies will also be quicker to achieve economic recovery. There are many similar cases, such as Sweden and the U.S. state of Texas, where the disposal of bad loans led to a rise in real estate prices. From these cases we can draw the empirical rule that economic confidence recovers quickly once the goal is in sight for completion of the process of disposing of bad loans and dealing with corporate bankruptcies.


As we work to restore confidence, what sort of economy should we be trying to create for Japan? Unless banks can get away from their present reliance on land as collateral for loans, land-backed lending will eventually increase again, and no matter how many bad loans are written off, a mountain of new ones will arise. Also, what sort of industry can serve as our future economic locomotive? Uncertainty about this has added to people's anxiety and dulled their enthusiasm to clear away the failures of the past.
From the perspective of the long-term economic climate, Japan's catch-up phase is over, and it must learn how to handle industrial development as a front-runner in the world economy. That means individual entrepreneurs taking risks and discovering growth areas by trial and error. And though it may seem counterintuitive to us under our present circumstances, the financial sector has a key role to play in this process as a supplier of risk capital.
Up to now the conventional pattern in Japan has been one that started with the emergence of growth industries; as they developed, these industries would display a hearty appetite for funds, to which the banks would respond by expanding their lending, thus securing a stable revenue source. In a front-runner country, however, a different pattern is required: The financial sector needs to take the lead in providing risk capital so as to allow the trial-and-error process by which new growth sectors are discovered, after which new industries can grow. Ideally, the financial sector should have been acting as the locomotive of Japan's economy since the 1980s; it is this sector that needs to be our leading industry in the period ahead. In this sense, the disposal of bad loans and the revival of Japan's financial system in a robust form, equipped with advanced risk-management capabilities, are essential for the development of the country's economy. We need a reform of the financial sector's business model.
The banking sector should have rethought its business model during the 1980s, when the major corporations were reducing their dependence on bank lending. I believe that the banking industry should have reorganized itself into two sectors-an investment-banking sector, concerning itself with mergers and acquisitions and project finance; and a small and medium-size business sector, consisting of institutions like credit associations and venture-capital funds.
In fact, Japan's banks focused on lending backed by land as collateral during the bubble economy years of the 1980s. But now land prices are not expected to rise, and traditional credit-screening methods will not work for managing the risks of lending to smaller businesses. If banks seek to achieve absolute safety in every loan they make, virtually no small businesses will qualify as borrowers. In making decisions on loans to small businesses, the method used for large enterprises-individual assessment of each would-be borrower-is not appropriate. What is needed is financial engineering to manage loans to groups of borrowers on a statistical basis in such a way as to achieve an appropriate balance between risk and return. For example, if there is a high probability that loans to 8 out of a group of 10 potential borrowers will produce a good return, and if this is sufficient to cover the risk of default by 2 of them, then all 10 loans should be approved.
A further important method of spreading risk is to remove loans from banks' balance sheets by securitizing debt and selling it to institutional investors. For this a market has to be established where securitized debt can be traded.
Banks are also said to have a structural problem. They are competing with each other in extending loans at interest rates so low that none of them can earn reasonable profits. But if banks adopted a credit-screening system to manage the balance between risk and return on entire portfolios of loans rather than on individual credits, this would naturally produce such profits. The banks should be able to do this much by dint of management effort even in a deflationary environment.
There are signs within the banking community that the business model is being changed along these lines. But one obstacle in the way of this trend is the fact that, because of their corporate culture, the banks have not been able to rid themselves of their reliance on land as collateral.
On a number of occasions I have often confronted bankers with the question: "Why can't the banks change their approach to lending?" The answers I have received-lending officers lamenting,"Headquarters won't approve a loan unless there's sufficient collateral," and people at headquarters complaining, "The branches don't send us proposals for loans at high interest rates"-suggest that there is a fault in the design of the banks' decision-making mechanism itself. So, having a surfeit of deposits and not being able to make other use of them, the banks invest their surplus funds in government bonds. Devising a new banking business model that abandons reliance on land as collateral is a task of the utmost urgency. The disposal of bad loans that resulted from land-backed lending is the first step.


Japan's economic policy must aim at an appropriate balance of three elements: (1) continued efforts to dispose of bad loans, (2) reducing deflation through monetary policy and other means, and (3) revamping the financial sector's business model. As regards the overall direction of the Koizumi administration, it has clearly stated its intention to promote bad-loan disposal and measures to counter deflation. The reform of the banks' business model is a major issue that will influence the Japanese economy's long-term growth potential. I believe that reform of the financial system will probably have a greater bearing on economic growth than will macroeconomic policy. Here I shall consider a number of areas of contention concerning the general direction of the present administration's policies. The disposal of bad loans requires an integrated revival of the banks and the debtor companies. It is important to set an appropriate time frame for the two objectives of this action: to allay anxiety by rehabilitating the financial system and to strengthen industry. The first stage is to conduct a strict valuation of banks' existing portfolios of loans through special inspections and other means in order to ensure that banks have set aside sufficient reserves against doubtful credits. Implementing the second stage-disposing of bad loans by rehabilitating or liquidating the corporate borrowers who have defaulted-can only be done by careful consideration on a case-by-case basis. Although stringent application of reserve requirements for bad loans may mean that some banks end up having insufficient capital, it should be possible to complete the first stage within a year or two. This is because it is simply a matter of implementing proper accounting practices. The second stage, however-rehabilitating or liquidating the debtor companies-will take time, since it involves changing these companies' actual business operations. We should be prepared for this to take seven or eight years-perhaps even a decade or longer.
In this light, I believe it is necessary to take a long-term view and think in terms of 10 to 20 years as the time frame for getting back the public funds injected into banks to shore up their capital. Methods like swapping a troubled company's debt for equity can be used to put companies back on their feet, and after a few years, or maybe a decade, when the industrial sector regains its health, the banks can dispose of their shares at a high price. The proceeds of such share sales can then be used to pay back the public funds invested in the banks.
It is not possible for the authorities to announce in advance whether or not further public funds are to be injected into the financial sector-or, if they are, when and where they are to be injected. But on the other hand, if market uncertainty is not cleared up, anxiety about the financial system will not go away. And actually nobody is asking for prior announcements about which banks will receive capital injections, how big they will be, or when they will take place. What the public is anxious about is whether, should the need arise, there would be sufficient financial resources and whether the injections would be carried out in a proper manner.
An amount of up to JPY70 trillion of public funds has been earmarked for the purpose of stabilizing the financial system, but only JPY15 trillion of this can be used for injections of capital into the major banks. One way of allaying the public's concern about whether this will be enough would be to increase the portion of the earmarked funds that can be used for the major banks. The suspicion that further injections of public funds might turn out to be a waste of money must also be allayed. A methodology needs to be established to assure people that such injections will lead to reform of the banks' business model and sustainable development of the financial system.
According to case studies from the some 130 countries around the world that have experienced banking crises, measures like giving preferential terms for capital injections of public funds to banks that have actively disposed of bad loans are effective in accelerating resolution of the problem. What is needed in advance is not information about which banks are to receive injections but a broader discussion of the methods to be applied.
One argument put forward by opponents of speedy disposal of bad loans is that this would bring about a chain reaction of unnecessary bankruptcies of small and medium-size enterprises. But why should strict asset valuation of banks' loans lead to "unnecessary" bankruptcies? One of the premises of this argument is that if a company gets classified as "in danger of bankruptcy" as the result of a strict asset valuation, regulations prevent a bank from continuing to lend operating funds to that company. (Making a new loan to a company in danger of collapsing would be regarded as a breach of trust on the bank's part.)
If that is the case, then surely all that needs to be done to prevent unnecessary bankruptcies is to change the regulations. If the label "in danger of bankruptcy" is the problem, then a separate category could be set up, and companies that fulfilled some objective, quantifiable criterion could all be classified under this category, irrespective of whether they have been classified as being in danger of bankruptcy. Perhaps the regulatory framework could be amended so that banks could make additional loans to such companies on the condition that they set aside a reserve of at least 50% of the amount lent. The reason for the large reserve requirement would not be some defect in the individual company but the fact that the economic climate as a whole is unfavorable. In other words, the bank would be required to set aside a large reserve on the basis of an assessment of the macroeconomic situation.


Clearing up the vagueness about rules for the disposal of nonperforming assets is a precondition for the market mechanism to function. Policy plays an important role in this. Only when the government establishes rules and fulfills the role of an impartial referee can the market function in a sound manner.
This is not the first time that Japan has had this sort of experience. After the "special procurement" bubble of World War I burst in 1920, disposal of the resulting bad loans was repeatedly put off until they eventually led to the Showa Financial Panic of 1927. Even after this, rehabilitation of the banking system made no progress and the economy was exhausted, leading ultimately to social unrest and militarization. It was not until after World War II that the colossal volume of bad loans (which ultimately amounted to 20% of gross national product) was disposed of in 1946 by freezing deposits and segregating new and old accounts. And it took another decade to write off the losses resulting from this segregation of accounts. From the collapse of the World War I bubble to the start of the segregation of accounts took 25 years, and if we include the writing off of the resulting losses, completing the whole operation took 35 years.
The bad-loan quagmire that Japan is stuck in today is comparable to the mess of its invasion of China in the 1930s. Our only option is to be prepared for a long haul lasting 10 to 20 years and patiently continue doing what has to be done; we must not hope to find some secret, magic stratagem to deal with the mess. If Japan once more takes a desperate gamble, as it did when it attacked Pearl Harbor because it could not bear to pull out of China, economic ruin will await us not far down the road. The history of the years to come will show this.

(The contents of this article are the personal views of the author.)

* Translated from "Fukyo dasshutsu ni wa nijunen kakaru," in Bungei Shunju, May 2002, pp. 198-207; slightly abridged. (Courtesy of Bungei Shunju)

July 24, 2002 JAPAN ECHO / August 2002

July 24, 2002

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