MW-13 -- WIMPING OUT ON REFLATION

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Issue No. 13
Tuesday, January 28, 2003
Tokyo

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Viewpoint: WIMPING OUT ON REFLATION

The Bottom Line:

o Concrete action by the banks to: a) accelerate NPL disposals
and b) bolster their capital without being forced to resort
to additional public funding and possible nationalization
has alleviated the immediate selling pressure on bank stocks
and on Topix. Thus, they just might be able to skate through
their March book closings without causing another "March
crisis."

o Indeed, the Japanese market could even experience a mild
relief rally as the IRC kicks in and begins buying NPLs of
corporate revival candidates from secondary creditors. As an
indication, the number of companies being priced for
bankruptcy (i.e., trading under 100 yen per share) has
decreased to 156 companies from a November peak of 214.

o Yet for all of the Koizumi administration's rhetoric about
eradicating deflation, it appears that they are wimping out
on aggressive targets to achieve this very same goal, having
pushed the target date to overcome deflation to after 2005.
This implies of course that the Japanese government has no
ace up their sleeve with regards to deflation. Even if
Koizumi can get his deflation-fighting BOJ governor candidate
passed by the Diet, the new governor will still have to deal
with a majority of policy board members who remain very
cautious about adopting dramatic inflation-inducing measures.

o In other words, while the Koizumi administration expounds on
eradicating deflation, it has in fact pushed out the
expectation envelop for the so-called "intensive adjustment
period" of low economic growth due to the disposal of NPLs
and other reform measures to fiscal 2004 and beyond.

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WIMPING OUT ON REFLATION
An old saying on Wall Street is "so goes January, so goes the year."
Well, there just went January. On Friday, the Dow Jones industrial
average lost 2.85% percent in falling 238.46 points. Last week's
losses in the US wiped out year-to-date gains, and only Nasdaq has
its head above year-to-date water by a razor thin 0.5 percent.The
dollar continues to tank, falling a record nine consecutive days
against the euro, the longest streak since the euro was launched four
years ago; the greenback is at fresh three-year lows. While global
investors have their eyes on the euro, it's the "kroner boys" that
have had the best gains of the world's currencies against the dollar:
The Norwegian kroner is up 29.2 percent against the dollar over the
past year, the Swedish kroner has gained 21.8 percent, and the Danish
kroner is up 21.5 percent. This makes the 13.8 percent appreciation
in the yen against the dollar look rather mundane.

However, the strength of the euro has not translated into
better-performing European equity markets. Indeed, for the year to
January 23, the MSCI global indexes (in dollars) show pretty tepid
performance for the euro markets, with the gains being made in the
Asian markets.

The real stars have been gold and precious metals, and CRB Futures
are up over 26 percent over the past year. While there were some
suggestions that this rally was about to end as US equities tried to
rally early in January, nothing could be further from the truth. The
rally over the past year merely represents the first leg of a secular
bull market.

Action, Not Talk
So far, the Japanese market has apparently bucked the tide of falling
global markets by rising while global stock markets continue to fall,
but this is largely due to the appreciating yen and a temporary
bottoming in the bank stocks. Last June, the bank stocks and Topix
went into a tailspin almost as soon as Heizo Takenaka was given the
additional task of running the Financial Services Agency (FSA), and a
debate began about possible forced nationalization of the banks. As
the Koizumi administration's "Comprehensive Deflation
Countermeasures" were announced in October last year, speculation
over possible nationalization of the major banks continued to roil
the markets. The nationalization option was even apparently discussed
at the Bank of Japan (BOJ) policy board meetings.

The banks' vehement resistance to the more stringent parts of the
Financial Revival Program (FRP) draft may have helped them win a
minor skirmish, but the Koizumi administration and FSA minister
Takenaka essentially got what they wanted. In other words, by using
the "possible nationalization" stick, they have effectively pushed
the major banks into more aggressive disposal of their bad loans and
instilled a new sense of urgency. After the FRP work schedule was
released, the major banks rushed to run new "special attention" loan
simulations for the March 2003 reporting period. The conclusion
(which Takenaka was telling them already) was "we need more capital."
The newly designated Industrial Revitalization Corp. (IRC) would not
be ready in time to help them with their March book closings. Thus
the big scramble to procure capital and dispose of bigger chunks of
their nonperforming loans (NPLs) was on.

Given the flurry of activity by the banks over the past month, it is
looking more likely that they will be able to skate past their March
31 book closings without precipitating another "March crisis," as it
was the banks' concrete action, rather than the announcement of the
FRP and the IRC, that has underpinned bank stocks and Topix. However,
the prospect of the IRC bailing out heavily indebted companies has
led to a noticeable shrinkage in the number of companies trading
under 100 per share (the short list of companies the market
sees as candidates for bankruptcy) to 156 from a peak of 214 in
November.

Wimping Out on Aggressive (Unrealistic?) Goals to Eradicate Deflation
The banks' action to shore up capital and accelerate NPL disposals
has bought the Koizumi administration some time. If the
administration can find a new BOJ governor willing to more
aggressively fight inflation and work with the administration in
doing so, that will buy some more time. Additionally, the IRC is
expected to begin operations by June of this year and to immediately
begin buying NPLs from the banks. Ostensibly, this will also
work to reduce perceived risk in the banking system. Takenaka, in
reviewing the prior year, said that, compared to the beginning of the
year, the situation had progressed from "the first station" on the
Mount Fuji of NPLs to a point where "the third station" is in sight,
and that he wanted very much for 2003 to be the year the government
achieves clear results in structural reforms.

Yet at the first meeting of the Council on Economic and Fiscal Policy
(CEFP) in 2003, the council ended up amending the "Structural Reform
and Medium-term Economic and Fiscal Perspectives" goals, extending
the intensive adjustment period for reforms until fiscal 2004 and
pushing the target date to overcome deflation to after 2005. This
implies of course that the Japanese government has no ace up its
sleeve with which to aggressively eradicate deflation. Moreover, even
if Prime Minister Junichiro Koizumi can get his deflation-fighting
BOJ governor candidate passed by the Diet, the new governor will
still have to deal with a majority of policy board members who remain
very cautious about adopting dramatic inflation-inducing measures.

In Money Watch No. 7, we pointed out the following as some of the
factors why we believed the IRC is being set up to fail.

1. The new agency will very likely NOT be politically
independent,
2. Historical experience in other countries has showed that such
organizations did poorly in corporate restructuring, and
3. The main banks of the worst debtors would still have their
NPLs and a major voice in the restructuring effort.
4. Most of the "dirty 30," i.e., the worst of the worst in the
banks' portfolio of NPLs, may not even be eligible for
revitalization by the IRC.
5. METI's Industrial Revival Law, upon which much of the IRC
criteria will be based, failed spectacularly with its first
test case, Daiei.

As we have looked closer into the political machinations involved in
launching the new agency, we see no reason to change our original
view of the IRC.

It has already become clear that the IRC will not be politically
independent. Indeed, a more likely scenario is a political and
bureaucratic group-grope. Firstly, the Liberal Democratic Party is
there in full force, lobbying the administration's team that is
tasked with setting up the new agency. They have already delayed the
process by insisting that a separate funding methodology be set up
for the IRC, instead of dangling it from the coattails of the Deposit
Insurance Corp. (DIC). While the IRC's role is ostensibly to consider
each case independently and without deference to any sector,
political or industrial group, the LDP project team is evidently now
firmly in the control of the Hashimoto faction, and moreover, the
team's director is a former construction ministry bureaucrat.

Secondly, the decision to buy or not buy NPLs for a corporate revival
will be the collective responsibility of the Cabinet. Both the
Ministry of Land Infrastructure and Transportation, which has
jurisdiction over the construction industry, and METI, which has
jurisdiction over the retail and distribution sectors, will be
consulted before a decision is made. Even some bureaucrats are
cautious. Transport minister Chikage Ogi said, "We must let the
market drive (corporate) consolidation." IRC minister Tanigaki has
also admitted that "there is a problem regarding how far the
government can intervene in individual company affairs." Ostensibly,
the decision to purchase NPLs will be vetted by an internal
"Industrial Revitalization Committee" consisting of individuals from
the private sector with direct experience, and the advice of related
ministries will be solicited based on each company's revitalization
plan. However, because the very survival of a corporation is at
stake, (1) it was considered necessary to develop a decision
framework that went beyond jurisdictional boundaries, and (2) it was
felt that the government should be perceived as being united in its
industrial revival efforts. Thus the government is now moving toward
having the responsibility for deciding which companies are
revitalized collectively by the Cabinet.

While requiring collective political responsibility, bureaucrats will
also be expected to bear some of the responsibility for corporate
revival. In other words, while the IRC will purchase NPLs and promote
corporate revival, the ministry with direct jurisdiction will be
expected to provide advice for the drafting of a revival plan and
other operational aspects, ostensibly to minimize secondary losses as
much as possible.

While much care and discussion is being made regarding the
establishment of the appropriate criteria, METI is already grousing
that in reality there are not any "objective" standards. In its view,
the only reason that quantitative criteria are to be established is
so the government can use them as an excuse to justify mistakes that
lead to secondary losses. On paper, METI already has fairly clear
criteria for corporate revitalization. The problem is that successive
claims for exceptions by other ministries have meant that troubled
companies could essentially ignore these guidelines.

The Industrial Revitalization Law standards stipulate certain
financial health criteria and productivity improvement yardsticks
that need to be met at the end of a three-year restructuring period.
The financial health yardsticks are: 1) profits at the ordinary
profit level, and 2) interest bearing debt levels that are within 10
times annual operating cash flow. The required productivity
improvements are: 1) an improvement in fixed asset turnover of over
5 percent as an indication of how efficient the company is utilizing
its productive assets, 2) an improvement of over 6 percent in
value-added per regular employee as an indication of employee
productivity, and 3) an improvement of over two percentage points in
ROE as an indication of how efficiently shareholder capital is being
utilized to produce profits. However, the company being restructured
has only to satisfy one of the above criteria. As additional
conditions, "shrinkage of business operations" and a "merger of more
than two companies" were included to prevent companies from taking
the easy way out in achieving the required benchmarks. However, the
ministries with jurisdiction over the construction and other
industries then created "special exceptions," which supposedly took
into consideration the individual characteristics of each industry.
In other words, companies could then ignore the criteria established
in the Industrial Revitalization Law.

NPL Purchases Above Current Market Value
The most important bone of contention will of course be how much the
IRC will pay for the NPLs. The IRC apparently intends to purchase
corporate NPLs at prices above current market values, as its
intention is to make it easier for banks to sell their NPLs. In
other words, the IRC will be purchasing NPLs at prices several times
higher than those offered by the RCC. The RCC in principle buys only
those NPLs in danger of bankruptcy at current market prices,
on average paying about 10 percent of the nominal value of the loans.
In contrast, the target market for the IRC is "special attention"
loans that ostensibly have a higher probability of recovery. The
pricing format that the IRC is expected to use is based on estimated
future risk-adjusted profits discounted to current market value,
using US discounted cash flow (DCF) methodology. As its methodology
assumes the indefinite continuation of operations and thus is a
"going concern" valuation, the price calculated is higher than
current market prices.

Considering the fact that the IRC could well become the highest
bidder in town for NPLs, the banks have lost no time in presenting
their deadbeat borrowers to the IRC as "revival" candidates. It
appears that Seibu Department Stores is being set up to be the first
corporate restructuring mapped out by the Industrial Revitalization
Corp. Seibu has decided on a restructuring plan under which it will
seek 230 billion yen in financial assistance, of which 220 billion
yen will consist of debt forgiveness, mainly by Mizuho Corporate
Bank, and six other core creditor financial institutions. It also
plans to have the IRC purchase around 200 billion yen in loans
extended to Seibu by some 30 creditors other than the seven core
creditors. The expectation is that by purchasing loans from banks
other than the core banks, the IRC can untangle the complex web of
creditor interests and clear the way for swift overhauls. Seibu, hit
hard by the bursting of the bubble, has been jettisoning assets as
fast as it can, selling off Credit Saison, Seiyu stores, Seiyu Food
Systems and Yoshinoya in addition to slashing personnel and closing
stores. The aim is to merge with Sogo Department Stores, which
declared bankruptcy in July 2000 but is now expected to emerge from
rehabilitation two years early. Sogo's restructuring success is
attributable to Shigeaki Wada, the former president of Seibu, who was
brought in to rehabilitate Sogo.

Ironically, however, the fate of the restructuring plan could also
rest in the hands of Shinsei Bank. If Shinsei Bank opts to take
advantage of a special loan buy-back provision that requires the
government to repurchase loans inherited from the old Long-Term
Credit Bank (LTCB) and whose value has subsequently plunged, the
resulting rift among bank creditors could disrupt the entire
restructuring package. It was Shinsei Bank that also effectively
pulled the plug on Sogo despite an abortive attempt by, of all
people, current IRC head Tanigaki and other conservative LDP members,
to save it.

Revival in Three Years
Considering the pace at which Seibu is already restructuring, and the
fact that Sogo's revival is two years ahead of schedule, they may
represent the "low-lying fruit" among potential revival candidates.
The company has consolidated debt of some 580 billion yen. If it gets
its financial assistance of 230 billion yen and the IRC purchases 200
billion yen of NPLs from secondary creditors, Seibu will emerge with
debt of only 150 billion yen and will be well-positioned to merge
with a revitalized Sogo.

But the real headache in the retail sector is Daiei. Last year Daiei
reduced its debt by some 430 billion yen through 230 billion in
debt-equity swaps, selling about three billion shares to a private
revival fund, and gaining 170 billion yen in debt forgiveness from
UFJ, Mizuho and Sumitomo Mitsui, its main creditor banks. Yet the
struggling retailer still has some 1.2 trillion yen in debt, and
its three-year revival plan has been a failure. Daiei was the revival
test case under METI's Industrial Revival Law, and METI's involvement
has actually been blamed for Daiei's slow restructuring, as it gives
the impression of government support. METI has asked Daiei to revamp
its existing restructuring plan, and it would be a real loss of face
for METI to end up having to present Daiei as a revival candidate to
the IRC.

For such firms, the real kicker of the IRC could be the three-year
revival time-frame. Tanigaki has stated that "the IRC will act as a
moderator to facilitate private-sector consolidation, but in the
cases where such consolidation is not possible, legal liquidation is
an option." The "Basic Policy for Corporate and Industrial Revival"
produced by the Industrial Revival and Employment Countermeasures
Strategy Headquarters also contains specific reference of the need to
"utilize the Industrial Revitalization Law or the Civil
Revitalization Law." Thus in principle, the holding period for NPLs
purchased by the IRC is three years. If the revival plan of a company
runs into difficulty during this period, the IRC could push for legal
liquidation膨ausing losses to the main bank. How seriously the IRC
applies this would be one litmus test of the organization's
credibility.

Basket Cases Would be Out of Luck
If the IRC really follows its own "strict" valuation criteria for
firms it accepts for revival, the market will soon discover that most
of the real basket cases in the banks' NPL portfolios will not be
eligible.

No less than 47.5 percent of these NPLs are in the real estate and
construction sectors. If wholesale/retail is included, the ratio
soars to 62.1 percent. Moreover, this combined ratio rose by 4.7
percentage points in the last year. A prior FSA probe of loans to 149
borrowers to which the banks had the most exposure revealed that 81
percent of the debt was by firms in these sectors, and 30 percent of
this was to just 34 borrowers. Other estimates show that the 25
most-indebted companies have some 43 trillion yen in interest-bearing
debts. This is the infamous "dirty 30" that was long ago identified
by reform proponents.

But by these measures, most of the trouble companies in the real
estate, wholesale/retail, textiles and construction sectors would not
make the grade, as in fiscal 2001 they had aggregate interest-bearing
debt to cash flow ratios of 24x, 18x, 20x and 18x, respectively, and
would need a Herculean restructuring plan to bring this ratio down
below 10x in just three years.

The original plan ostensibly would have provided for 10 trillion yen
in funds for NPL purchases and to have its funding under the
"financial revival account" of the DIC. The problem was that the
upper limit of funds for this account was 12 trillion yen, of which
4.5 trillion yen was already used in the prior liquidation of LTCB
and Nippon Credit Bank, leaving 7.5 trillion yen in funding to be
shared with the Resolution and Collection Corp. (RCC). Pressure from
the LDP's task force has already forced the Koizumi administration to
seek separate funding for the IRC, and it is obvious at least to
observers that the IRC will require much more (as much as 10x more)
than 10 trillion yen to properly do its job.

Originally, the administration had been considering paid-in capital
of some 30 billion yen, increasing this up to 50 billion yen as
circumstances required. But because the IRC's time frame for
revitalizing corporations is three years, it would need to front
load its NPL purchases in the first two years, meaning it would need
to be capitalized at over 100 billion yen. The media is now
suggesting capitalization of more like 200 billion yen, with over
40 billion yen coming from the banks themselves. The administration
has already asked the BOJ, the Development Bank of Japan and other
government-backed financial institutions to provide funds, but the
BOJ and the Development Bank have so far demurred due to the still
uncertain nature of the IRC's methodology. Even government agencies
are doubtful the IRC will be successful!

Who Will Be the Eventual Buyers?
While the basic outline for the IRC is coming together at a rapid
pace (in Japanese government terms, at least), there has been little
if any consideration been given to who the final buyer of these
credits might be. The IRC is basically adopting a short-term strategy
in order to minimize the probability that NPLs they purchase become
secondary losses. At the current juncture, it is assumed that the
final buyers of resold credits will be "private sector revival
funds," "corporates" and, in certain cases, "financial institutions."
However, it is far from certain that such investors will find the
price at which the IRC wants to sell attractive. Rather than just
"revival," isn't there additional value-added that needs to be
provided? There has been virtually no discussion of the "selling
prices" at which these credits could be profitably liquidated.

Finally, there is the abysmal track record of the Japanese
government's efforts to deal with the NPL problem to date. The RCC
has undergone two reiterations since 1994 and still is ineffective in
making a significant dent in the NPL mountain. METI's Industrial
Revival Law has failed in its first attempt to revive its first
patient, Daiei, and one hears nothing of the Stock Purchasing
Organization that was the first attempt to get the banks to shed
themselves of "excess" stockholdings, ostensibly so they could more
aggressively dispose of NPLs. Instead, we now have the BOJ directly
purchasing stocks from the banks. Given such a track record, it is
understandable that even the BOJ and the Development Bank (which is
in some respects a competitor of the IRC) have their doubts about the
new agency.

-- Darrel Whitten

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