The Nikkei 225 index's fall below the 8,000 mark has left Tokyo buzzing with now familiar talk about a "March crisis" of the Japanese financial system. The key index's decline is also fueling the already raging policy debate over measures to enliven the economy as well as the stock market. Making a big ado about a possible financial crisis in March-although it has never materialized-has become sort of a fiscal year-end ritual in Japan's financial circles. Why does this happen year after year? Are there any factors that make this year different?
Companies and banks with large stock portfolios are required to value their shareholdings at market prices at the end of their accounting year on their earnings statements. Since most Japanese companies close their books at the end of March, slides in stock prices in March below the purchase prices generate unrealized losses on their stock portfolios, hurting the firms' bottom lines.
When a company falls into the red, it finds it much tougher to pay back its debt or even becomes insolvent. Loans to money-losing companies eventually become nonperforming loans, sapping the profits and damaging the balance sheets of the banks. Increased paper losses work to take a bite out of banks' capital.
Since banks must keep the ratio of their capital to their assets, such as loans, at a certain level or higher to meet the international capital adequacy requirement, shrinking capital forces them to reduce assets.
Financial weakness of banks
So undercapitalized banks need to cut off loans and recall credit lines to shore up their capital bases. These moves inevitably shrink the flow of funds from banks to their corporate borrowers, thereby increasing corporate bankruptcies and prodding companies into more radical restructuring for survival. The upshot is a serious economic slump that arouses fear about a real financial crisis.
Japanese banks with massive bad loans and over-borrowed companies have been in serious financial trouble for many years. A dive of stock prices only acts as a trigger, prompting a latent crisis at banks and their corporate borrowers. The underlying cause of the current situation, where tumbling stocks are threatening to precipitate a financial panic, is the long-festering financial weakness of banks and debt-ridden companies in non-financial industries.
If there is any factor that makes this year's "March crisis" different, it is the change in the international environment. The biggest worry is the U.S. economy, which could be hit hard by the negative effects of the war with Iraq.
Consumer spending in the United States, the main engine of growth in the country, is more sensitive to stock market trends than in Japan. A big market drop would seriously crimp consumer spending, and the resultant sudden weakening in buying would then batter the overall economy, pushing down stocks further, in a vicious cycle. A downturn in the United States would bite into Japanese exports to the country and deliver a heavy blow to the many Japanese companies that depend on sales in the U.S. market for much of their profits.
There are many economists who think the U.S. economy of today is on a much firmer footing than the Japanese economy after the collapse of the asset-price bubble. Still, the economic situation in the United States demands close attention in the coming months.
Except for this aspect, however, there is nothing really special about what is happening now in Japan.
In each of the past several years, the Japanese economy was hit by a stock market tumble when the fiscal year neared its end in March. But the root cause of the stock market decline is a chronic disease called "banking weakness," as I have mentioned.
Various specious theories have been offered to explain the falls of the stock market. One blames the collapse of the IT bubble, while another traces it to the effects of the Sept. 11 terror attacks. Since many events take place in the world economy every year, it is easy to find reasons for a stock market slide. This time, a global stock market retreat due to the Iraq crisis is, on the surface, the main force driving down Japanese stocks. But the fact that should not be overseen is that banking weakness at home is at the root of the situation.
Let us focus on the problems with the banking system to examine the genesis of the March crisis mechanism.
Prime Minister Junichiro Koizumi has pledged to ensure that there will be no financial crisis. "There was a lot of talk about a September crisis, and then about a March crisis" last year as well, Koizumi pointed out, "but these crises didn't come." Didn't we really see any crisis?
A financial crisis conjures up images of bank runs, with panic-stricken depositors rushing to bank counters to withdraw their savings, and of stock market crashes due to panic selling by investors. Preventing a stock market drop from triggering such a financial panic is what Koizumi means when he promises that there will be no financial crisis.
Some experts, however, have very different views about a financial crisis. Researchers at the World Bank recently published a series of reports on financial crises that occurred in various countries in the past. They argued that the banking system becomes dysfunctional when bad loans in the system surpass a certain ratio of the overall bank lending. And they have defined a financial crisis as such a situation. The World Bank report that examined the conditions in Japan concluded that the country has been consistently in the middle of a financial crisis as they define it since the beginning of the 1990s.
If a financial crisis only means a full-blown panic, no crisis can occur in Japan. Since the government has extended its guarantee of all ordinary bank deposits, there is no reason for depositors to stampede into banks to get their money back.
The real question is not whether there will be a panic. It is the public confidence in the banking system and banks' financial strength that is so weak as to make people worrying seriously about a panic. This is a real financial crisis confronting us, regardless of what is happening in the stock market.
Politicians are already talking about a supplementary budget for the new fiscal year to provide fiscal stimulus to the floundering economy and also placing much hope on the Bank of Japan's monetary easing under the new governor.
There is also a growing chorus of calls for a variety of band-aid measures to prevent a possible crunch at the end of March, such as the postponement of the proposed curbs on banks' shareholdings and the freezing of market-price accounting.
But the heart of the matter is the weakness of the financial system. While showing a crisis-time readiness to take any action to prop up the sagging stock market, the government is taking no unusually strong steps to attack the urgent problems with the financial system. If the administration decides to keep seriously undercapitalized banks alive, that would only increase the financial burden on taxpayers.
Capital inadequacy means a smaller stake for shareholders. A smaller shareholder stake, meaning less to lose, tends to make a business more inclined to making risky, do-or-die bets. Even if the bets turn sour, leading to huge losses, the mess will be eventually cleaned up with taxpayers' money through steps like government-supervised disposals of the failed banks. This is a textbook case of moral hazard.
Regain public confidence
To prevent such a situation, it is crucial for the government to conduct rigorous bank examinations to see whether there are any banks that are undercapitalized. If the government finds an undercapitalized bank, it should quickly put the institution under state control. The Financial Services Agency is now performing special inspections into banks. The public need to pay close attention to the results.
Meanwhile, the Financial System Council is studying possible new ways to inject public funds into the banking system, with an eye on announcing the conclusions by the middle of the year. The government has moved up the date to May in response to the recent downfall of stock prices.
The council should devise new approaches to the use of taxpayer money on the assumption that Japan is already in the grip of a financial crisis, instead of coming up with steps designed for a hypothetical financial panic.
The best prescription to avert the "March crisis" and the "September crisis" consists of aggressive efforts to cure the ailing, enfeebled banking system fundamentally that would help regain the public confidence in banks and other troubled businesses.
* This article was published in The Asahi Shimbun on March 17, 2003 and International Herald Tribune / The Asahi Shimbun on March 26, 2003. No reproduction or republication without written permission of the author and The Asahi Shimbun.
March 26, 2003 International Herald Tribune / The Asahi Shimbun
