MW-03 -- It's Going to Cost You

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

Issue No. 3
Wednesday, October 30, 2002

Viewpoint: It's Going to Cost You

The Bottom Line:

o Economics, Fiscal and Financial Services minister Heizo
Takenaka has been literally bowled over by a virulent storm of
protest against his hard-landing scenario to clean up the
banking sector. The banks have a point when they claim that
the government keeps changing the goalposts, but they honestly
can't say they have not been forewarned, as the government
clearly stated its intention in April 2001 and again in early
2002 to clean up the worst of the nonperforming loans
(NPLs)within three years. The only difference now is the
Koizumi administration meant what it said.

o To achieve his reformist agenda sometime in this century,
Prime Minister Junichiro Koizumi has resorted to trying to
circumvent the old iron triangle, with key personnel from the
private sector to lead the charge. At the same time, he is
playing "good cop, bad cop" games to deflect as much of the
resistance and political anger away from himself, ostensibly
to maintain his political effectiveness within the Liberal
Democratic Party and the coalition parties.

o Opponents to the hard landing scenario being painted by
Takenaka have caught on pretty quickly that the real agenda is
to force the major banks to accept more government capital
infusions. However, what the Koizumi camp doesn't seem to
fully realize is that it will be expensive ... most likely
multiples of the JPY15 trillion the government has earmarked
for "emergency financial system stabilization measures." The
need to fund this with significantly more government borrowing
could well slam-dunk not only the stock market but the bond
market as well.

Barely in his new post for three weeks, Economics, Fiscal and
Financial Services minister Heizo Takenaka has been bowled over by a
virulent storm of protest from opposition politicians who have
submitted a no-confidence motion against him in the Diet, the LDP's
leadership (which has drawn up its own version of deflation
countermeasures), the banks, which threaten a lawsuit if his proposals
are made, other ministers such as METI chief Takeo Hiranuma, to
economists and bank analysts themselves -- all who claim that
Takenaka's medicine for what ails the banking sector will not only
kill the banks but also the economy in which they operate.

But when Koizumi first came to power, the top priority of his vision
for reform was to solve the banking sector problems. Many attempts
have been made, including more stringent audits of bank loan books, a
plan to force them to reduce their holdings of equities to below their
core capital by 2004 and a stated intention of placing a three-year
time limit to clean up the NPLs, with measures to dispose of one-half
of the total amount in one year, and up to 80 percent by the second

Despite the intense heat Takenaka is receiving, Koizumi has publicly
defended the "hard-landing" approach, emphasizing to the Diet that not
only does the banking problem present a serious drag on economic
recovery, but it is also something that Japan cannot afford to leave
unresolved. It is a big wall that Japan must climb over with bold and
flexible actions.

The banks do have a point when they claim that the government keeps
changing the goalposts. As of the end of March, reported NPLs were
JPY43.2 trillion, up JPY9.6 trillion from the previous year. Of this
increase, however, some JPY5.7 trillion arose because of more
stringent loan classification criteria. Since 1992, Japan's banks have
written off JPY81.5 trillion worth of bad loans and have JPY13.4
trillion of loan-loss reserves, compared to total loans of JPY512
trillion. These write-offs and loan-loss provisions have been taken
after taxes were paid. Thus, including reported NPLs, the cost of bad
loans to the Japanese banking sector has already reached 25 percent of

But private sector analysts still claim that reported NPLs of JPY43
trillion greatly understate the true extent of the problem, especially
as the banks classify NPLs for the same borrower differently and
because some of the most seriously indebted, financially precarious
borrowers are being treated as good credits. In other words, the
true extent of Japan's bad loan problem could be more like 40 percent
of the GDP. The banks themselves have not been particularly helpful in
conservatively trying to estimate the true extent of the problem, even
though they have already directly received JPY9.3 trillion from the
government and have been coddled heretofore by the Bank of Japan,
whose unprecedented loose money policy and quantitative easing has
done essentially everything possible from the monetary perspective to
ensure that banks can maintain profitable interest rate spreads.

Moreover, the banks cannot claim that they have not been adequately
forewarned. In an April 2001 Emergency Economic Package, the
government required major banks to completely remove from their
balance sheets in three fiscal years loans to companies that were
"bankrupt," "effectively bankrupt" and "in danger of bankruptcy." An
additional guideline called "Measures for Developing a Stronger
Financial System" was released this April by the Financial Services
Agency; it required the banks in principle to remove 50 percent of the
loans in the above three categories within one year and 80 percent
within two years.

The sheer scale of the problem is enough to make anyone balk at a
concentrated push to achieve a solution, especially the politicians
who have been the recipients of abundant political funding, not only
from the banks, but from the construction, real estate and retail
sectors that account for the bulk of outstanding NPLs. Because senior
LDP lawmakers are as deeply implicated as any in Japan's banking mess,
a hard-landing approach to the problem is a direct affront to the
infamous iron triangle, i.e., the symbiotic relationship
between the LDP, protected businesses, the ministries that supposedly
control them, and organized crime.

In other words, the banking problem is but the tip of an iceberg of a
problem that permeates Japan's socioeconomic structure. Simply put,
anyone who seriously tries to implement a hard landing for the banks
risks a full-scale attack by the most deeply entrenched and powerful
interests in Japanese society. Indeed, if Takenaka's hard core
proposals actually see the light of day, he may even become physically

But Koizumi, already bruised by continuous skirmishes against such
entrenched interests in his efforts to reform the public road
corporations and the postal system, most likely realizes more than
anyone else the difficulty in trying to address the problem through
conventional political channels. His predecessors have been attempting
to do just that for the past 10 years -- to no avail. This fact was
pointed out by Koizumi in his recent comments to the Diet: "Over the
past 10 years, neither borrowing to fund fiscal stimulus nor tax cuts
have worked. Has not fiscal policy reached its limits?"

While his predecessors also established endless study committees to
debate the issue and come up with recommendations, it was inevitably
left to the bureaucrats and key LDP lawmen for implementation.
Moreover, cabinet selections were conducted strictly according to
the relative strength of different LDP factions, giving the prime
minister little if any leeway for policy implementation. Any proposals
that seriously challenged the iron triangle's power base were thus
either ignored or watered down to the point of being ineffective.

Koizumi's tactics differ markedly. Firstly, he largely ignored
factional alignments in the selection of his cabinet. When presented
with an opportunity to do so, he has consistently chosen
non-politician reformist hard liners with no entangling alliances with
the iron triangle. As his tenure coincided with a historical
consolidation of the ministries themselves, his influence over
economic policy through the Council for Economic and Fiscal Policy is
unprecedented for a postwar Japanese prime minister. Finally, he has
attempted to sidestep bureaucratic impediments by combining the posts
of economic and fiscal policy with financial sector supervision. Thus
Koizumi is the antithesis of the typical postwar "placard" prime
minister ・ to the point that his opponents now equate his dictatorial
policy making to that of Adolph Hitler.

Nowhere are his "good cop, bad cop" tactics more noticeable than with
the current push to clean up the NPL problem. Notice that he
discouraged suggestions that a recapitalization of the banks hinges on
the passage of a new law. Instead, the Koizumi administration chose a
wider definition of the existing "financial emergency" framework.
Getting a law passed in the Diet could drag the process on for months,
and Koizumi would like to see action now.

While the press is describing both Koizumi and Takenaka as being
surprised by the virulence of the opposition to a policy that has not
even been formally announced yet, he has been known to take actions
and make comments that elicit immediate negative responses, which help
him to early on identify his true opponents on any issue. Takenaka's
"draconian" (in terms of the prevailing mindset) measures may be
deliberately hard line, in order to create a sense of urgency, set the
agenda and push expectations in the desired direction. If Koizumi is
as politically savvy as I believe he is, he knew very well what the
LDP, the opposition, the bureaucrats and the banking sector's response
would be -- first alarmed and then resistant.

By taking the most extreme approach, Koizumi would be extremely
satisfied to achieve even 50 percent of what Takenaka proposes, which
would be 50 percent more than what he could have hoped to achieve with
a more gradualist approach.

I believe that there hasn't been enough questioning of why the Bank of
Japan chose its bold decision to buy stocks from the banks when it
did, and why the Koizumi administration chose to propose such
hard-line policy initiatives when it did. The economy is beset by a
deflationary spiral that is getting worse. The stock market continues
to tank, creating even more valuation losses for the banks that erode
already paper thin real capital ratios. Indeed, several of the weakest
banks may not survive the fiscal year anyway, unless the government
somehow finds the resolve to act decisively.

However, one fundamental question being asked by hard-landing reform
opponents does need answering: How exactly would the proposed bank
reform measures lead to disposal of bad loans? Indeed, critics claim
that the plan is designed to trigger a financial crisis, which will
lead the government to inject public funds into the banks.

The BOJ's position on the state of NPLs is that these bad credits are
inextricably linked with structural changes in the financial and
corporate sectors. Moreover, as the nearly JPY90 trillion of NPLs
disposed of by the banks since 1992 represents 80 percent of the loan
increase during the "bubble" period, the NPL problem is increasingly
an issue of disposing of newly generated NPLs that have nothing to do
with the bubble period. Thus, the problem as the BOJ describes it is:

1. Substantial new NPLs are being continuously generated,
2. unrealized stock gains at the banks have become unrealized
losses, and
3. the earning power of the banks is insufficient to cover credit

If one looks at the economic value of Japanese bank loans, it becomes
apparent that Japan's banks do not have enough earnings power to cover
credit costs. For example, the banks in FY2001 produced core operating
profits of JPY5.5 trillion, close to the historical high of JPY5.6
trillion. Yet with NPL disposals of JPY9.7 trillion in FY2001, the net
write-offs of NPLs exceeded operating profits for the 8th consecutive
year since FY1994. In FY2001 the banks removed NPLs according to the
government's schedule, and in FY02 essentially met the government's
required JPY10 trillion in NPL write-offs.

When Japan was negotiating with the Bank of International Settlements
(BIS) over its implementation of an 8 percent haircut for the capital
ratio of banks operating internationally, they argued forcefully that
as substantial unrealized gains on securities holdings were a hidden
asset for the Japanese banks, these securities holdings should be
considered when measuring their regulatory capital ratio. The BIS
relented and allowed unrealized gains on marketable securities to be
counted as a part of Tier 2 capital for the Japanese banks.
These unrealized securities gains that the banks pushed so hard for
have now become unrealized losses. In FY2000, the major
internationally active banks were able to report JPY1.5 trillion in
stock gains that boosted core operating profits of JPY4.6 trillion,
which were a noticeable help in realizing NPL disposals of JPY6.1
trillion. In FY2001, losses on stocks actually reduced the JPY5.5
trillion core profit by JPY2.4 trillion, while the banks were
compelled to realize JPY9.7 trillion of losses from NPL disposals. In
addition, while their reported capital adequacy ratio was 10.5
percent, well above the required 8 percent, their unrealized
securities gains had shrunken to JPY300 billion and are now unrealized

As of the second half of FY2000, the reported regulatory capital of
the internationally active Japanese banks was JPY37.9 trillion, or
11.03 percent of risk-adjusted assets. By the second half of FY2001,
this ratio had fallen to 10.6 percent, as while risk-adjusted assets
had declined by just under 8 percent to JPY316.6 trillion, Tier 1 and
Tier 2 capital had declined by over 11 percent to JPY33.6 trillion.
Moreover, excluding public funds and deferred tax assets, core Tier 1
capital had plunged 30 percent during the same period. With current
stock market values, this can only deteriorate further in FY2002. With
the stock market below 9,000 on the Nikkei 225, unrealized stock
losses for the major banks exceed JPY5 trillion. With market value
accounting, this would imply a shrinkage of Tier 1 capital (as the
after-tax losses on the market value of securities must be used to
offset regulatory capital) of JPY3 trillion, or essentially half of
core bank capital, meaning that core capital will have imploded to a
level only 38 percent that of second-half FY2000 levels -- even
without the more stringent measures that Takenaka plans to introduce.

The most reportedly contentious items of the "Takenaka" plan are: the
adoption of discounted cash flow analysis to classify NPLs, and
stricter application of deferred tax assets. Deferred tax assets for
all banks as of March had swelled to JPY10.6 trillion, representing a
JPY3.5 trillion increase over the past year, and they have grown to
36.5 percent of Tier 1 capital from around 20 percent the previous
year. For the internationally active banks, Tier 1 capital was 54.4
percent of total regulatory capital at the end of March, but deferred
tax assets were 39 percent of Tier 1, while public funds received were
25 percent. In other words, "real" capital was only 2 percent of
risk-adjusted assets. If these banks record unrealized securities
losses commensurate with current stock market levels, that ratio
shrinks to 1 percent or lower.

If, according to the Takenaka proposal, the major banks reduce the
ratio of their deferred tax assets to 10 percent of Tier 1 capital,
the reported capital ratio of all of the major four banking groups
except Tokyo Mitsubishi would fall below the 8 percent BIS capital
ratio requirement and ostensibly necessitate their withdrawal from
international markets. Keep in mind that it was these banks'
international operations that produced near record levels of core
operating profit. In addition, if discounted cash flow analysis were
adopted, these reported capital ratios would shrink even further as
the banks were again forced to up their NPL liquidations.

The clear implication is that the stringent measures included in the
Takenaka proposal would effectively force even Japan's largest banking
groups to accept a government cash infusion. Moreover, if the
government were to convert the non-voting preference shares it owns of
the major banks to voting shares, it would automatically become one of
the major shareholders in these banks and would be able to force the
banks to accept capital infusions.

The question that does not seem to have been duly considered by the
Koizumi administration's hard-landing proponents is: Can the
government afford a major bank bailout and the cost of major economic
stimulus to ameliorate the obviously negative impact on Japan's
economy? The Japanese government has earmarked JPY15 trillion for
"emergency financial system stabilization measures." However, it has
not budgeted for this JPY15 trillion.

It cost the South Korean government JPY15 trillion in public funds to
clean up its banking sector, but considering that Japan's economy is
over 10 times the size of South Korea's, JPY15 trillion is probably
not enough by far, especially when already understated NPL balances
alone are nearly JPY50 trillion. Japan's Labor Ministry has estimated
that 650,000 jobs would be lost with an accelerated liquidation of
JPY15 trillion in NPLs.

Using the same arithmetic, liquidating nearly JPY50 trillion of NPLs
would imply unemployment of over 2 million and push unemployment
toward 10 percent. Back-of-the-envelope calculations of the negative
impact on GDP imply at least a 1 percentage point shrinkage in GDP.
Moreover, if major banks are nationalized, it implies that the value
of these nationalized banks' stock goes effectively to zero. If this
were to occur, I would not be surprised to see the Nikkei 225 trading
under 5,000.

The Bank of Japan's position on the state of NPLs is that these bad
credits are inextricably linked with structural changes in the
financial and corporate sectors. In other words, for every NPL, there
is a struggling company on the other side of the transaction. With 80
percent of the NPLs being accounted for by the real estate, wholesale,
retail, services and construction industries, where corporate
restructuring efforts should be focused is pretty clear.

In this regard, the private sector members of the Council for Economic
and Fiscal Planning have become increasingly irritated because the
numerous proposals put forward regarding tax cuts, NPL disposal
schemes and other suggestions to try and turn the deflationary tide
have heretofore gone largely ignored and are collecting dust in some
government cabinet.

One recurring suggestion is to combine the operations of the
Resolution and Collection Corp. (RCC) and the Development Bank of
Japan (DBJ). Both organizations assumed their current form in 1999.
While the RCC has a corporate rehabilitation function, there is
widespread criticism that its efforts in this regard have been weak.
Moreover, the scale of operations for the Development Bank of Japan
heretofore has been less than one-tenth of the scale (at a mere
JPY1.7 trillion) that would be required for a full-scale corporate
restructuring program to offset accelerated NPL liquidations. In
addition, a new fiscal investment and loan structure from FY2001 means
that the Development Bank of Japan and other government agencies no
longer have automatic access to the pool of postal savings and public
pension money through the Fiscal Investment and Loan Program.
Ostensibly, they would have to issue agency bonds for future project
funding. And while a combination of the RCC and the DBJ would
ostensibly simplify debt consolidation and corporate restructuring
greatly by consolidating the debt under one creditor, providing the
borrower with credit guarantees and acting as the coordinator for a
consortium of banks and other financiers for restructuring funds,
Japanese banks would be in no position to provide the massive amounts
of new capital that would be required for a full-scale program.

Let the barbarians in. The only realistic recourse would be to open
the process up to foreign capital and to remove the remaining barriers
to foreign takeovers. METI and other government agencies already
publicly are promoting foreign M&A and have recently removed important
impediments such as allowing foreign firms to use stock swaps in
takeovers of Japanese companies. There remains, however, the deeply
rooted fear that a major NPL cleanup would result in many more
instances of foreign capital and management running major Japanese
banks and corporations. For most of the old iron triangle, this is a
possibility they want to avoid at all costs.

Thus the Koizumi administration is between a rock and a hard place.
Allowing the deterioration in the financial sector to run its natural
course leaves the Japanese economy extremely exposed to external
shocks and to an unprepared-for financial crisis. At the same time,
pushing for a hard landing through accelerated NPL liquidations and a
full-scale recapitalization of the banks, if handled badly, could very
well lead to the same result.

It appears that the Koizumi administration's game plan is to get the
hard-landing scenario in place first, then use whatever economic
fallout it generates to pressure for: a) the full cooperation by the
Bank of Japan in providing liquidity and even inflation targeting, and
b) quick passage of legislation for short-term economic stimulus,
including but not limited to new tax legislation, and from a
longer-term perspective, full-scale support for corporate
consolidations and restructuring.

However, the very act of pulling out all stops to provide economic
stimulus to offset the hard landing in the banking sector could well
result in a sharp upward spike in interest rates, as the bond market
vigilantes vote with their feet and push interest rates sharply
upward. This would not only greatly increase the cost of government
funding but also further exacerbate the balance sheet pressure on the
weaker borrowers.

-- Darrel Whitten

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Written by Darrel Whitten

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