Policy Update 003
Coping with Debt Deflation in Japan
Assessment of the Comprehensive Counter-Deflationary Package
Rebuilding of the Japanese banking sector requires resolution of both the stock and flow problems surrounding banks, accumulation of nonperforming loans (NPLs) on the stock side, and low profitability of the banking business on the flow side. In promoting banks' disposal of NPLs, it is important to ensure that the banks make accurate judgments regarding the fate of each borrowing company, by adopting strict standards for asset assessment. Meanwhile, to improve profitability, banks must reinforce governance and make innovative changes to their business model. The proposed but aborted re-examination of the tax-effect accounting system (capital reinforcement) - an area in which the government's comprehensive counter-deflationary package is said to have become "toothless" - had been aimed at the pursuit of these two goals. Despite this setback, however, the Program for Financial Revival has managed to implement a series of other hard-to-swallow yet important measures, and there is still hope for the actual implementation of the package. The true value of the program hinges on how soon proposed key measures, such as another round of special inspections of banks by the Financial Services Agency and the subsequent announcement of gaps between banks' own assessment and the results of the FSA inspection, can be implemented. If the government fails to act quickly, the program would ultimately be "toothless." In this sense, the package is to face the true test in its implementation.
Measures to Pull Japan out of Economic Disarray
The current state of the Japanese economy is deemed modest debt deflation, in which prices continue to fall as companies and banks - suffering under the weight of excessive debts and NPLs, respectively - are forced to sell their goods and assets at losses. Thus, while deflation is a cause of the further increase in NPLs, the continuation of the NPL problem is also a cause of deflation. Reducing banks' NPLs (excessive debts held by companies) is a vital policy for severing the mechanism of debt deflation (or the vicious cycle of the continuation of deflation and an increase in NPLs), and this is the policy agenda that must be given top priority if Japan is to be pulled out of its ongoing economic disarray.
In promotion of the disposal of NPLs, it is indispensable to proceed with the reconstruction of borrowing companies in a systematic manner, and to prepare an efficient safety net to cope with the short-term increase in bankruptcies and unemployment.
As a measure to facilitate corporate reconstruction, it is of the utmost importance to ease restrictions on banks' tax-free disposal of NPLs, which are overly stringent and have been driving creditor banks to force small and medium-size corporate borrowers into bankruptcy. It must be noted that a financial revival and an industrial revival cannot be completed at the same time, and thus two sets of measures should be implemented on separate timetables. Measures for banks - stricter asset assessment standards, reinforced provisioning requirements, and the infusion of public funds - should be implemented within several months, while measures for companies - liquidation, reconstruction, and business transfer - should be carried out in an orderly manner over a period of several years, as such schemes involve employment adjustments.
As for the safety net, the government should promptly announce the amount of planned expenditures on employment-related measures (for instance, pledging to spend ¥10 trillion over three years), to provide the general public with a sense of assurance. However, we must not forget that fiscal reconstruction will become an issue of top priority when the two- to three-year period of intensive NPL disposals is over, and when the private-sector economy is back on a path of sustainable growth in several years. Therefore, in the implementation of fiscal measures to strengthen the safety net, the government must clarify the long-term fiscal reconstruction plan, the implementation of which should begin in several years.
In accordance with the progress of the disposal of NPLs and corporate reconstruction, the Bank of Japan must help abate deflationary pressure by providing sufficient liquidity in the money market.
*This is a translation of the Japanese article published in the Nov. 19, 2002 issue of the "Shukan Ekonomisuto (Weekly Economist)" magazine.
November 19, 2002
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