Japan Should Focus on Rebuilding Confidence

TOKYO — The collapse here of one major financial institution after another, and the mounting credit crunch affecting small and medium-sized companies all over the country, have finally made it acceptable in Japan to talk about the use of public funds to remedy the financial crisis.

This is a major step forward in the policy debate in Japan, because politicians and bureaucrats had been extremely timid about discussing the use of public funds after a massive public outcry that erupted two years ago over using public money for scandal-ridden housing-loan companies.

Although the taboo on use of public-sector funds has been broken, the content of the recently announced $77-billion (or 10-trillion yen) package by the ruling Liberal Democratic Party falls far short of what is really needed to repair the system. That’s because political leaders are still insisting that this money will be used only to help depositors and not financial institutions, except in truly exceptional cases, namely to help a healthy bank take over the business of a failed one.

*

While “saving the depositors” sounds more acceptable than “saving the banks” to the nation’s taxpayers, the financial problem in Japan is not limited to just a few institutions. Rather, it is a systemic problem affecting the entire system.

More important, the greatest threat to the Japanese economy today is the credit crunch, not the failure of financial institutions. Saving the depositors with public funds will do nothing to alleviate the credit crunch. This was the key reason the securities market remained unimpressed despite the bailout package.

The credit squeeze is the result of a capital crunch being experienced by Japanese banks, many of which have never been well-capitalized. Furthermore, the fact that a large part of Japanese bank capital is made up of unrealized capital gains on cross-shareholdings means the recent weak stock market has severely weakened the capital base of the banking system. That in turn has been forcing the banks to reduce their assets in order to achieve mandated capital-asset ratios.

Japan’s top 19 banks, for example, have already indicated that they will be reducing their assets to the tune of 15 trillion yen, or about $115 billion, by the end of March 1998. When all financial institutions are counted, the figure could reach double, making it the equivalent of 6% of gross domestic product. Such a massive financial contraction in an already weakened economy could prove fatal. In fact, Japan is on the verge of falling into a vicious cycle whereby the credit crunch weakens the economy, which further depresses the stock market, which in turn forces the banks to call in more loans.

Possible ways out of this downward cycle include renewed fiscal stimulation in order to lift both the economy and the stock market, or recapitalization of the banks so that they are no longer vulnerable to fluctuations in stock prices. Although both of these moves are needed, the highest priority should be assigned to rebuilding public confidence in the financial system, given that so much of the erosion of public confidence in the economy has been generated by the failures of major financial institutions.

Efforts should be directed toward strengthening banks’ capital bases. If all $77 billion were used in this way, assuming a capital-to-asset ratio of 8%, it could alleviate credit problems of $963 billion--or 12.5 times the capital injection. This is no small sum.

On the other hand, if it were used to help depositors, the $77 billion would be a drop in the bucket when it comes to addressing the problem. (The LPD’s Seiroku Kajiyama, the original proponent of the bailout package, has put the size of the bad-debt problem at $920 billion.)

*

Unfortunately, many Japanese are still obsessed with the idea of holding someone responsible for the banking mess. The media, in particular, have been arguing that the bank executives responsible for bad loans should be put in prison before taxpayers are asked to accept the use of public funds to help the banks. Although some bankers are indeed less than innocent, no comprehensive measures can be put in place as long as this kind of witch hunt is underway. Indeed, many bankers are likely to reject government support if it comes with the condition that they will be made personally responsible for their past business decisions.

In this sense, Japan today is like a ship with a hole in its hull. Instead of repairing the hole and stopping the water from getting in, people are engaged in a fierce debate about who is responsible for the hole. As long as such a debate is tolerated and enjoyed, no serious effort to stop the ship from sinking can be expected.

At some point, when people realize that many on the lower decks are already underwater and that the ship is sinking fast, the debate will shift to how best to stop the water from getting in. It is at that point that we will all be able to look forward to a brighter future for Japan. Meanwhile, the fact that the credit problems are progressing relentlessly suggests that it will not be too long before more bad news on the economy surfaces.