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

Issue No. 10
Tuesday, December 17, 2002

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The Bottom Line:

o The Bank of Japan's sudden decision to begin purchasing stocks
from the banks could well have been the result of stress-test
exercises between the BOJ and major banks as well as non-bank
financial institutions.

o A comparison of the structure of Japan's flow of funds in
fiscal 1989 and fiscal 2000 reveals that a successful
recycling of the financial assets of individual savers by
domestic financial institutions to prop up the bond market
despite massive increases in outstanding JGBs and the
replacement of the domestic financial institutions with public
financial institutions for loans, and foreign investors for
stocks, allowed Japan to keep its financial system from
buckling under the weight of "the overwhelming magnitude" of
the problem. That's right, the great irony is that by
accounting for over 50 percent of trading in Japanese stocks
and owning some 19 percent of total outstanding shares,
foreign investors have actually facilitated maintenance of the
status quo.

o As long as the smooth recycling of individual financial assets
into the bond market continues, and foreign investors as well
as public financial institutions continue to be the main
suppliers of risk capital, the status quo could continue for
another 10 years -- that is, without some event that places
unforeseen, multifactor stress on the financial system, or
without a "hard landing" that would force accelerated disposal
of NPLs as is suggested in the Financial Revival Program.

o Equity investors in either case are stuck between a rock and a
hard spot. The smooth recycling of individual financial assets
is a structural negative for the stock market, while a forced
accelerated disposal of NPLs could precipitate a solvency
crisis that would also involve a substantial loss of
shareholder capital.

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Conceptualizing the Sum of All Fears
Recent reports coming from the Bank of Japan's Financial Markets
Department indicate that the BOJ and the banks themselves haven't been
completely asleep at the switch and that they are at least trying to
learn from past mistakes. What the Financial Markets Department has
been doing is conducting "fire drills" with major financial
institutions (both banks and non-banks) in the form of macro-stress
tests to conceptually, at least, figure out how resilient Japan's
banking system would be to stresses caused by unforeseen changes in
market and economic conditions, which, by definition, could not be
predicted in advance. The stress tests cover three basic categories
(sensitivity to the stress, historical examples and hypothetical
examples) and some 166 different stress-test scenarios.

First, let's look at economic stress. For example, assume a global
economic contraction similar to the Asian currency crisis of 1997.
What impact would this have on Japan's economy today and on her
banking sector? The BOJ's macro-economic model indicates that Japan's
nominal GDP would decline by 2 percent year on year for two
consecutive years given a contraction in the global economy similar to
that experienced during the Asian currency crisis. However, the BOJ's
model does not take into account the additional impact from the
negative feedback from financial markets, i.e., the impact that the
reaction in equity prices, foreign exchange rates and interest rates
would have on the economy. If this feedback is considered, a similar
decline in Japan's GDP could occur with a milder downturn in the
global economy but a more virulent reaction by the equity, forex and
bond markets.

Next, banking sector stress. The four major banking groups' holdings
of equities at the end of March 2002 were some 21 trillion yen. In
terms of sensitivity to market levels, a 10-point decline in the Topix
would result in a 200 billion yen decline in the value of their stock
holdings. In addition, the economic value of their loan assets would
also decline with widening credit-risk premiums. If fiscal spending
were used to try and counter the negative impact on the economy, this
could exert upward pressure on interest rates, which in turn would
hurt the value of bank bond holdings, which were 38 trillion yen at
the end of March 2002. However, barring a dramatic increase in
government borrowings, what hurts the banks' equity portfolios
actually helps their bond portfolios. Thus a 10 percent decline in
stock prices, if it was accompanied by a corresponding increase in
bond prices, would mean that the banks' net benefit would be 1.7
trillion yen in terms of the unrealized capital value of their stock
and bond holdings. Thus ostensibly, they would be recording net
valuation gains as opposed to valuation losses at the end of the
reporting period. At the same time, however, nonperforming loan
disposals, or more likely loan-loss provisions, would be larger than
originally forecast, meaning reported net income losses due to NPL

What about sharp swings in the financial markets? The stress tests use
past sharp short-term swings in financial markets to conceptualize
what would happen today. In recent history, the sharpest swing in
long-term rates was a more than 105 basis point rise in Japanese
government bond (JGB) yields over the course of a month during the
Trust Fund Bureau shock in December 1998. As for equity prices, the
sharpest short-term move in stock prices in recent history was the 18
percent decline in the Topix on Black Monday in 1987. For the currency
market, sharp swings in yen-dollar exchange rates of 10 percent on the
upside and 11 percent on the downside were considered. In addition, a
sharp swing in credit spreads of 200 basis points between JGBs and
BB-rated corporate bonds was considered, similar to what happened over
a six month period up to March 2001 after Mycal defaulted in September

Learning Curve
The Bank of Japan maintains that Japan's financial system has changed
appreciably since 1997-1998, when Japan came the closest it has been
during the Heisei Malaise to financial meltdown. Then, two "crises"
developed simultaneously. The first was a liquidity crisis, where even
large banks had difficulty obtaining funds. The second was a solvency
crisis, where the banks were having difficulty maintaining their 8
percent capital ratios. As all banks tried to dump assets to overcome
the crisis, they triggered a solvency crisis. What was learned?
According to the BOJ, the banks subsequently moved to reduce their
foreign exposure, and the BOJ now is providing ample liquidity at
essentially zero rates to prevent a liquidity crisis. In addition,
since 1997-1998, corporations have shifted to direct finance, issuing
corporate bonds and commercial paper instead of depending on loans and
the stock market for funds. Structurally, there is now a safety net
under the financial system and a playbook (including funding pools)
for what the government should do if such a crisis appears imminent.

Despite one round of capital infusions following the 1997-1998
financial crisis and ostensibly learning key lessons from the crisis,
even the banks themselves admit that, while they have enough capacity
to absorb one risk factor (ostensibly one or two standard deviations
outside the normal probability curve), they would still have
difficulty dealing with several simultaneously -- a scenario that is
much more likely to occur in the real world. The other issue is
timeframe. If the multiple stresses emerged gradually, the system and
individual banks would be better able to implement countermeasures,
but it is the short-term pressure that represents the most risk.

It was just this sort of "fire drill" that undoubtedly led the Bank of
Japan governor to suddenly announce in October that the bank was
planning to buy holdings of stocks directly from the banks. The
central bank also issued its view and recommendations of the NPL
problem in its November 2002 quarterly bulletin. As deputy governor
Yamaguchi stated in August 2002, "what matters most is the magnitude
of lost capital and its distribution -- i.e., who in the system has to
absorb the loss ... the magnitude is overwhelming, and concentrated in
the banking sector."

To ensure financial system stability even given a "sum of all fears"
scenario, the central bank felt strongly that: a) the banks needed to
reduce their shareholdings; b) and quickly dispose of their
NPLs; and c) the government should be prepared to inject public funds
where necessary, using Article 102 of the Deposit Insurance
Corporation law, with the BOJ standing watch as the lender of last
resort. The BOJ has already started purchasing stocks from the banks
and is now announcing their outstanding purchases every 10 days, until
the total reaches 2 trillion yen, ostensibly by September of next
year. Meanwhile, the government has expanded the scope of operations
for the Bank Shareholding Acquisition Corp., which ostensibly had also
been set up previously to purchase stocks from the banks. The Diet
passed a bill recently to allow this organization to buy bank stocks
from companies, as the banks unload some JPY10 trillion of company
stocks by fiscal 2004.

Why Hasn't the System Buckled Yet?
The issue that continues to puzzle foreign observers, however, is why
the system hasn't buckled from what BOJ deputy governor Yamaguchi
describes as "the overwhelming magnitude" of the problem. If the
flow-of-funds situation were actually as serious as indicated by
plunging stock and property prices, Japan should have experienced a
financial and/or a fiscal crisis long ago. But an analysis of the flow
of funds since the bursting of the bubble shows that, so far, the
"overwhelming magnitude" of the problem has been facilitated by:

1. An increase in the nominal value of personal financial assets
of 405 trillion yen.
2. A shift in personal financial assets away from risk assets,
into principle-guaranteed assets, mainly current deposits and
3. A similar shift away from risk assets and loans by domestic
financial institutions into JGBs.
4. A corresponding shift in the provision of risk capital from
domestic financial institutions to the public sector and
foreign capital.
5. A shift in corporate funding sources from loans and stocks to
straight bonds and CBs, and a shift to a fund surplus in late

Essentially, Japan has been so far able to absorb huge capital losses
in the stock market and property markets by recycling abundant
personal financial assets increasingly being pooled in the banking
system and the government-controlled postal savings system into JGBs,
which the government in turn used to stimulate the economy with
successive public-works expenditures. Interest-rate income foregone by
individual savers is being used to keep rates ultra-low and to keep
the yield curve steep to shore up bank profits. The rising financial
assets of public financial institutions (which have risen from 24
to 37 percent of total assets during the same period) also provided
demand for JGBs, but their more important role has been to supply risk
capital (loans). While loans of private sector financial institutions
remained largely stable, loans by public financial institutions
essentially doubled during the period. In terms of JGBs, holdings in
both the private-sector and public-sector financial institutions have
nearly tripled between fiscal 1989 and 2000, allowing outstanding
government bond balances to swell from 149 trillion yen in fiscal 1989
to 409 trillion yen by fiscal 2000 with no perceptible negative impact
on interest rates. In addition, the corporate sector's shift into a
fund surplus late in 1997 added more available liquidity.

Thus, while poor economic conditions, falling interest rates,
financial-sector fragility and structural unwinding of cross-held
shares have been very tough on stockholders as well as property
holders in Japan, this has in turn given the Japanese government more
leeway in issuing JGBs than it would have had under normal
circumstances. The result is structurally bad for the stock market but
structurally good for the bond market.

The Foreigners' Ironic Role
The crucial role that foreign investors have played in supplying risk
capital during this period (particularly to the stock market) cannot
be understated. As cross-holdings among financial institutions and
corporations were systematically unwound, foreign investors (and to a
smaller extent, domestic pension funds) took up the slack, with their
share of ownership of Japanese equities soaring from 4 to 19 percent
during this period. Moreover, their share of annual turnover in the
Japanese equity market exploded to 53 percent from 13 percent 11 years
ago. In other words, without active participation from foreign
investors, the Nikkei 225 could have been at 6,000 or 5,000 long ago.
Thus, in a perverted fashion, foreign investors are also guilty of
preserving the very same status quo they have so bitterly protested
during the Heisei Malaise.

Here is where Heizo Takenaka's Financial Revival Program comes in. As
long as no "sum of all fears" scenario emerged to topple this delicate
apple cart, Japan could continue as it is for perhaps another 10
years. But to some, when Heizo Takenaka picked up the BOJ's "fire
drill" exercise and began to run with it, the situation suddenly
changed from a theoretical fire drill to a more immediately probable
reality. Suddenly forcing the banks to shore up their obviously
insufficient capital could have instigated a solvency crisis.
Meanwhile, Takenaka insists that a solvency crisis does not
necessarily involve a liquidity crisis, and moreover, if the
government stood ready to nationalize the banks, even a solvency
crisis could be averted.

Rather than betting on the success or failure of the Financial Revival
Program and the Industrial Revival Program, MoneyWatch believes
investors should first have an early warning system in place for a
possible solvency or liquidity crisis. During 1997-1998, one early
warning indicator was the "Japan premium," but as the banks have taken
countermeasures since, the Japan premium has all but disappeared.
Another indicator would be a sharp expansion in credit spreads between
JGB yields and BB or other corporate bond yields, such as was seen
following the Mycal default.

-- Darrel Whitten

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Written by Darrel Whitten

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