MW-02 -- Koizumi's Good Cop, Bad Cop Games

J@pan Inc Magazine Presents:
Weekly Financial Commentary from Tokyo

Issue No. 2
Friday, October 25, 2002

Viewpoint: Koizumi's Good Cop, Bad Cop Games

The Bottom Line:

o "To conquer deflation, the government and the Bank of Japan
will act as one," insists Prime Minister Junichiro Koizumi.
Investors, however, have been here before and will not be
drawn in easily by promises of action simply because their
experience tells them that the Japanese government during the
Heisei malaise has always delivered too little, too late.

o A more common scenario has been analysis paralysis and
political quagmire. If what the reformist hawks are promoting
comes to pass, there is a valley of pain and a still
uncertain end game on an invisible horizon. Moreover, the
financial reform hawks have fast run into a wall of
resistance. The inevitable result will be a much watered-down
version that could well please no one and in the end make no
appreciable difference.

o Despite the fact that he will go down in history as presiding
over the worst destruction of capital in Japan's history,
Koizumi is still Japan's best hope for achieving enduring
reforms. His "good cop, bad cop" political strategy has not
only resuscitated his popularity, but it has ensured
his political viability. The problem is that all this reform
stuff creates uncertainty, and any seasoned investor will tell
you that markets hate uncertainty more than anything else. But
while any news of new corporate bailouts (such as Daiei) and a
softer landing for bank reform will be a short-term positive,
these offer no assurance of long-term survival nor of a
new-found ability to create shareholder value. Thus, as we
pointed out last week, we can only hope that the
Japanese government and investors root for the winners, not
the losers.

"To conquer deflation, the government and Bank of Japan will act as
one." That's what Koizumi told Parliament last week. He also told a
group of supporters that "if there is an effective way to use taxpayer
money in our restructuring efforts, we will." Economics, Fiscal and
Finance Minister Heizo Takenaka also talks a good ballgame, but it's
far from sure that Koizumi and Takenaka are really singing off the
same song sheet. There is even strong disagreement within the Takenaka
reformist "dream team" about what measures it will push the government
to implement in its promised package of deflation-fighting measures.
Koizumi apparently gave Takenaka the green light to push for an
integrated, "hard landing" approach to cleaning up the banking mess
when he appointed him to head up the Financial Services Agency (FSA).
But observers aren't sure just how strong a mandate Takenaka actually
has to clean up the banking mess. The Takenaka appointment to head the
FSA in addition to his other duties has incensed old-guard Liberal
Democratic Party members, the Banks, the Ministry of Finance and the
FSA rank and file, who see him as a "paper driver" (i.e., someone who
has a license to drive a car, but who has never actually driven a
car). The opponents to a hard landing have surrounded the Takenaka
group like white blood cells attacking a biological intruder in the
human body. First of all, appointing a non-politician ruffled more
than a few feathers, then the banks and their supporters in the LDP
gathered their forces for a full-scale political assault, and even
Koizumi has also apparently pulled the reformist rug out from under
Takenaka in dismissing any talk of including new laws in the current
extraordinary Diet session that would ostensibly allow more aggressive
capital infusions into the banks. Koizumi is also sticking with his 30
trillion yen cap on government bond issues, as he does not want to be
seen as acquiescing to another supplementary budget full of
pork-barrel public-works programs that would play into old-line LDP
power politics. Finally, even the issue of tax cuts is looking iffy.
Koizumi's apparent vision of "deflationary countermeasures" is thus a
two-staged process and certainly not as comprehensive a set of
countermeasures as the Takenaka-led hawks had in mind.

The most hawkish view in Takenaka's FSA advisory committee is Takeshi
Kimura of KPMG. His scenario is to convert the preference shares that
the government bought in March 1999 in lieu of prior capital infusions
into regular voting shares. The government would then be in the
position as a major shareholder to force the banks to make more
realistic loan-loss provisions and to accept capital infusions. If
they did not, as major shareholders, the government could vote for new
management. The convertible period for all of the major banks except
Mizuho Financial Group (Tokyo Mitsubishi Bank refused capital
infusions in the first place) has passed. If the government converted
its preference shares into voting shares now, it would own 52.1
percent of Mitsui Trust Holdings, 23.7 percent of UFJ Holdings, 20.9
percent of Mitsui Sumitomo and 11.4 percent of Sumitomo Trust. But
others argue that the current nonperforming loans (NPLs) were not
created by current bank management and that the government wouldn't be
able to run the banks any better. In addition, the conversion of these
convertible shares would incur valuation losses for the government.
The issues that the "dream team" committee are currently mulling

1. Accelerated NPL disposal policies
a. Stricter audits of the banks' doubtful loan portfolio and
increased loan-loss reserves based on a
discounted cash flow methodology.

b. Adoption of US standards for deferred tax assets currently
counted in bank regulatory capital.

c. Clearly define management responsibility as part of more
strict corporate governance to avoid moral hazards.

d. Try to bring about bank capital infusions within the
confines of current laws (i.e., assume no new law will be
forthcoming soon).

e. Strengthen coordination of the Bank of Japan and monetary

f. Use of the Resolution and Collection Corp. to purchase NPLs
from the banks.

g. Consider extending the moratorium on bank deposit payoff
caps for two more years.

2. Structural Reform Policies

a. Tax reform

b. Revitalization of the capital markets

c. Regulatory reforms

d. Revitalization of metropolitan areas

e. Employment safety nets

f. Small and medium-sized company safety nets

g. Revitalization of companies and industries

Analysis Paralysis and Political Quagmire
Anyone who has observed this process before is deservedly skeptical.
The "dream team" was only able to disclose the main issues currently
under study on the 17th , and many are doubtful that the complete
package of deflation countermeasures will be ready by the end of the
month. If it is, it will most likely be a watered down version due to
political expediencies. Indeed, anyone who believed that the advisory
panel and the government could put together a well-planned and
comprehensive anti-deflationary package within the time-frame
indicated can be accused of smoking something. Throughout the entire
Heisei malaise, the Japanese government has always over-promised and
under-delivered on countermeasures. The measures that are finally
implemented are always too little, too late. The clearest example of
this pattern was in late 1997, when Japan came extremely close to a
financial meltdown. The Japan premium was soaring, and financial
institutions as well as regular corporations were failing in
domino-like fashion as a credit squeeze hit. Hokkaido Takushoku Bank,
Yamaichi Securities and Sanyo Securities were just a few of the
companies that failed. The governor of the Bank of Japan took the
extraordinary step of appearing on TV and pleaded to the populace for
calm, claiming the situation was under control. In reality, the credit
squeeze that swept through the financial markets took the authorities
by surprise, and it was not until almost a year later, in the third
quarter of 1998, that a comprehensive financial system "safety net"
package passed Parliament, and the markets began to stabilize.

Meanwhile, Corporate Bailouts
At this same time, other interests are pushing to have the Japan
Development Bank, which is funded by public pension money and the
postal savings system, to pump in more good money after bad in saving
the worst-of-the-worst dud borrowers. Daiei, the poster child for
Japan's most deeply indebted firms, received a whopping 520 billion
yen in debt forgiveness only this March, but the banks (and the Japan
Development Bank) have been asked to fork over some 60 billion yen
more to invest in a "Daiei reconstruction fund," which would end up
owning 30 percent of Daiei's outstanding stock. To do the same favor
for the eight general construction contractors and real estate
companies currently on the dole from the banks would require 750
billion yen in additional funds to get their collective financial
positions to a level equal to that of all listed companies. In
addition, other industry "safety net" proposals are aimed at using
more taxpayer money to extend and greatly expand the scope of credit
guarantees for medium- and small-sized firms.

Good Cop, Bad Cop
Thus it is very understandable why the market has recently lost
patience with the Koizumi administration and with the apparent lack of
solid progress on key reform issues. In addition to the decades-long
litany of un-addressed issues in an weakening banking sector and in a
bloated public sector, global stock markets are now in a secular bear
market. The US$-denominated MSCI World Index is down 21.5 percent
year-to-date, with the euro region off 26.7 percent, led by a 33.3
percent plunge in Germany. This compares with a 24 percent fall in the
US and an 11.4 percent drop, or 15.6 percent in local currency terms,
in Japan. Keep in mind, however, that the MSCI Japan is basically a
blue-chip index and that the broader market indexes have done much
worse than the MSCI Japan.

Koizumi is basically playing a "good cop, bad cop" routine. Koizumi
came into power on a tsunami of support for his reformist platform. At
one point, it appeared his days were numbered, as political opposition
and mistakes by his foreign minister, Makiko Tanaka, forced Koizumi to
drop her. But Koizumi's popularity is recovering. In other words, his
shield and sword of public support that protects him from the reform
resistance has regained its luster as he has gotten back on the
reformist track. The recovery in popularity was partially due to his
historic visit to North Korea, but also because he has made the right
reformist moves when necessary. When Koizumi chose Takenaka as his
chief bull terrier of the financial reform campaign, it was the first
time in history that one minister has been in charge of economic,
fiscal, IT and financial policy. When he has had an opportunity,
Koizumi has consistently chosen reform hawks for key posts. He chose
Nobuteru Ishihara as his minister of state in charge of regulatory and
administrative reform specifically to have a go at reforming and
privatizing the biggest white elephants in Japan's bloated public
sector. While Ishihara's reform initiatives were fought tooth and
nail by LDP Diet members whose pork barreling in Japan's national
budget for public roads has been a source of their political power,
there has been progress, albeit slow and painful. Koizumi's other
controversial reformist picks include Masaharu Ikuta, former chairman
of Mitsui OSK Lines, as president of the Postal Public Corp., and
Naoki Inose, writer and Public Road Corp. critic. Ikuta was chosen for
his private sector restructuring expertise and enthusiasm for reform.
Inose was chosen to serve on a key committee that is deliberating the
privatization of the Public Road Corp. The Diet members in the Public
Road Corp. pork barrel continue to fight Inose as fervently as they
fight Ishihara and Takenaka, but the choice of such a reform hawk was
a key message to voters.At the same time, the prime minister has
distanced himself from these hawks enough to be able to play the good
cop when politically expedient. Thus, while his reform lieutenants
push for accelerated reforms on several fronts, he has taken care to
remain above the mud-wrestling matches. While some of the young lions
within the LDP criticize him for his apparent lack of leadership on
key issues such as financial reform, Koizumi is merely placing enough
distance between himself and his lieutenants to be able to neutralize
any serious threats to his basic, underlying reformist agenda. If
Koizumi were to be as openly zealous and unyielding about specific
reform issues as his lieutenants, he could well compromise his
effectiveness in being able to wheel and deal through traditional LDP
power channels.

The bottom line is that, as long as Koizumi remains in power, there
will be forward progress in the reforms Japan so badly needs. Due to
the complicated political matrixes involved, however, progress in
reforms may at times be hardly apparent and will always be too slow to
satisfy the financial markets. Consequently, while the Koizumi
administration has presided over the largest destruction of equity
market capitalization in Japan's history, he remains Japan's best hope
for enduring change for the better in Japan. Unfortunately, the
evolutionary reforms being put in place by the Koizumi administration
are hard to measure for investors, who see only short-term uncertainty
with accelerated financial sector reforms and no clear end game on the
other side. As any seasoned investor can tell you, markets hate
uncertainty more than anything else. Conversely, any news of a new
corporate bailout will be a short-term positive, especially for those
companies currently being priced for bankruptcy. However, a bailout is
no assurance of long-term survival or of a newfound ability to create
shareholder value. Thus as we pointed out last week, both the Japanese
government and investors should root for the winners, not the losers.

-- Darrel Whitten

"What You Should Read After Irrational Exuberance"
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Written by Darrel Whitten

Edited by J@pan Inc staff (


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