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

Issue No. 18
Wednesday, March 5, 2003

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The Bottom Line:

o The appointment of a new BOJ governor has not changed the fact
that no one has a credible program to fix Japan's deflation
given the history of the "Japan disease" and the political
forces that are at loggerheads over the problem.

o Actually, the ball is in the government's court as to who will
fix the banking system and push through needed reforms. The
BOJ can only agitate and provide "moral suasion" for such
reforms, while keeping the markets flush with cash to prevent
a financial system "accident" and shooting for price
stability. (Forget about inflation targeting. Just achieving
zero inflation, a goal already embraced by the BOJ, will be
difficult enough). Given this reality, if too high
expectations are placed by the government (and big business)
on Fukui to help save the economy from stagnation, he could
become the new scapegoat for Japan's problems.

o In choosing a trio of career bureaucrats from Japan's three
main financial policy bodies (CEFP, MOF and BOJ), PM Koizumi
has opted to maintain a balance of power between the
ministries and the central bank, ostensibly to achieve
better-coordinated monetary and fiscal policy. Whether the
result is better coordination or monetary muddle remains to be

o MoneyWatch sees no end to the "slow rot" other than putting
committed reformers in charge of vital policymaking
institutions. In this regard, the common thread of the new BOJ
governor and deputy governors is reform. Deflation cannot be
cured through monetary easing alone, and that makes structural
reforms more important than ever. However, as even Heizo
Takenaka has pointed out, there is no magic wand for Japan. He
believes it will take 5-10 years to see the results of the
Koizumi administration's and other reform efforts, with 2003
foreseen as being an "intensive adjustment period" for
structural reform -- and that's the best-case scenario.

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Koizumi: "I Chose Someone With Stability and Credibility"
"I chose someone with stability and credibility," prime minister
Junichiro Koizumi said of his naming Toshihiko Fukui as the next
governor of the Bank of Japan (BOJ). Fukui is known as an
independent-minded former BOJ deputy governor with an Osaka merchant
upbringing. But what the premier really meant to say is that he went
for the least controversial choice in choosing Fukui instead of
someone like the "eccentric" Nobuyuki Nakahara. Koizumi had for weeks
said that he would choose a "deflation fighter" but gradually softened
his definition of that role. He also said that he wanted someone from
the private sector, but ended up choosing three career bureaucrats
formerly with the BOJ, the Economic Planning Agency (EPA) and the
Finance Ministry (MOF), respectively.

In choosing a trio of career bureaucrats from Japan's three main
financial policy bodies (MOF, BOJ and the Council on Economic and
Fiscal Policy, or CEFP), Koizumi has opted to maintain a balance of
power between the ministries and the central bank, which feuded
publicly during former BOJ governor Masaru Hayami's 5-year tenure.
In the end, it appears that business leaders persuaded Koizumi to
select Fukui as the successor, according to the Nikkei. "Fukui is the
best candidate to be the next governor," said Yotaro Kobayashi, chief
of the Japan Association of Corporate Executives (Keizai Doyukai). The
financial sector apparently agreed, according to sources at the big
four bank groups. However, financial services minister Heizo Takenaka
apparently had wanted a candidate from the private sector who would
implement financial policies aggressively. He was not as supportive,
but without a viable alternative, he also agreed to the Fukui

Politically, the apparent retreat by Koizumi from reform bluster to a
safer path only solidifies the suspicion that he may be only
pretending to change things. The prime minister's failure to implement
most of his grand reform menu since coming into office in April 2001
has left him with even fewer options now that the economy is on the
verge of stalling yet again. "The fact that Fukui was chosen shows how
bad the state of the government is: yet another old boy, no new life,
no new nothing, just more of the same, slow rot," observed one critic.

Central Banker's Thankless Task
It is hard to find a more thankless job than the governor of the Bank
of Japan. Policymaking in Tokyo is akin to a merry-go-round -- the
arguments are circular, never-ending and prone to fits and starts.
Solid economic theory seldom clouds the discussion, at least among the
politicians. Unfortunately, however, there is one topic that elicits
clear and universal agreement in Japan these days. That is that former
BOJ governor Hayami has failed at his job.

During his 5-year term, he staunchly defended the BOJ's newly won
independence and sent investors and lawmakers consistent messages
about where he stood. But on Hayami's watch, Japan endured two
recessions and continues to suffer one of the longest bouts of
deflation in postwar times. The stock market is at 20-year lows, and
major banks as well as insurers are teetering on the brink of
collapse. When Hayami was appointed, the Asian financial crisis was
raging, and a handful of Japanese banks had collapsed.

Hayami has shown unswerving support for a strong yen, and he only
reluctantly eased monetary policy, often after months of political
pressure by the government and ruling politicians. While interest
rates were lowered to historical lows during his tenure -- the
official discount rate was lowered to record low levels, and in 1999,
the central bank pushed short-term market rates to zero, and the BOJ
took unconventional steps toward "quantitative easing" -- the BOJ's
and the government's policies always seemed out of sync during
Hayami's tenure. Said one former member of the BOJ's policy board, "He
turned out to be stubborn and an ideologue." During Hayami's tenure,
Japan's main financial policy organs -- the CEFP, the Financial
Services Agency, the MOF and the BOJ -- often feuded publicly. The
repeated and public barbs by policymakers prevented agreement on a
large-scale plan to combat deflation and clear the massive overhang of
nonperforming loans plaguing the nation's banks.

Fukui, while being the "stable and credible" choice, was not without
his critics during his prior tenure at the central bank. While he
spent most of his career at the BOJ, he was forced to resign in 1998
along with then-governor Yasuo Matsushita to take responsibility for a
scandal involving BOJ officials. Critics argue that the failure of the
BOJ's fiscal policy after the economic boom of the 1980s was Fukui's
responsibility, as he held the positions of executive director and
deputy governor of the bank during that time. While the government
(and big business) have placed their bets on Fukui to help save the
economy from stagnation, he could become the target of criticism in
due time.

While Hayami had been demonized for keeping too tight a grip on
Japan's money supply, he has already taken the BOJ into uncharted
territory by driving interest rates to zero, adopting quantitative
easing and flooding the financial markets with liquidity. Japan's
politicians ignore the fact that the BOJ has far less latitude to
stimulate economic growth than meets the eye. For years, governments
around the world worked to reduce budget deficits and thereby
effectively ceded the main thrust of economic policy to the central
bankers. But the onus in Japan at least has long since shifted back to
the government to accept responsibility for controlling inflation and
stimulating GDP.

For the BOJ to become potent again, the government needs to
restructure the financial system, free the economy of impediments to
cross-border competition and capital flows, and improve corporate
governance. Now, as the central bank pumps record amounts of liquidity
into the system, the banks merely use the money to buy more government
bonds. As banks are not lending, there is no "multiplier effect,"
which is a major mechanism for transmitting monetary policy to the
real economy. It is the government's responsibility to chop away the
political logjams that prevent, just to name an obvious example, a
more resolute cleanup of the banking system. If Fukui throws the ball
back to the government as well, he, too, may become the "bad guy" or
the "obstructionist," just as Hayami was. In fact, he can only agitate
for bank and other structural reforms, keep the money markets well
funded to prevent a financial crisis, and attempt to achieve price

No Big Lurch in Monetary Policy Expected
The consensus take is that Fukui's accession to BOJ governorship
signals a continuation of the orthodox approach to monetary policy
advocated by Hayami. Died-in-the-Keynesian-wool central bankers such
as Fukui believe that the deflation that has restricted economic
growth over the past decade is the result of price readjustment after
years of high growth during the bubble economy of the 1980s. Monetary
policy as well as budgetary measures could help to soften this
transition, but it is not a substitute for meaningful, long-term
structural reforms as advocated by Koizumi. Fukui told Dow Jones
Newswires in a separate interview that the BOJ will maintain a bias
toward easing policy to avert any concerns of tightening liquidity in
financial markets and will promote expectations of a stable financial
environment. "The BOJ has a role in calming anxiety in financial
markets such as stemming concerns about a lack of liquidity or the
impact of financial institutions' disposal of bad loans," Fukui said.

Under Fukui, the Bank of Japan is likely to maintain its current
approach of supplying the market with ample funds, but unlikely to set
an inflation target. One of the new deputy BOJ governors, Kazumasa
Iwata, does favor the introduction of inflation targeting. Iwata has
in the past urged new approaches to monetary policy, including an
inflation target. But Iwata will be badly outnumbered on the BOJ's
board in this regard, just as Nobuyuki Nakahara was during his tenure
on the board. The other new deputy BOJ governor, Toshiro Muto, is also
cautious about inflation targeting. In August 2001, Muto said that at
a time when prices continue to fall, the BOJ should as a central bank
pursue deeper discussions rather than talk about setting an inflation

Big on Reform
Fukui is expected to focus on revitalizing the banking sector to
bolster the simulative impact of an easy monetary policy. "From the
perspective of defending against various shocks, the current
monetary-easing policy should be carried out with confidence," Fukui
said in an October 2002 interview with the Nikkei. Fukui also said,
"An inflation target will be difficult to use as a magic wand." In
last fall's interview, Fukui said serious thought should be given to
bolstering banks' capital bases in order to help restore their
financial intermediary role. He stressed the importance of carrying
out bad-loan disposals in order to maximize the economic stimulus
impact from monetary policy. He is therefore expected to be actively
involved in the government's efforts to bolster the financial system
and rehabilitate the operations of Japan's banks. His belief that
there should be an overhaul of the management of financial
institutions in the midst of the banks' bad-loan crisis is an
extension of this market-driven philosophy.

Former vice finance minister Muto, a new deputy governor, has reform
views similar to Takenaka's, believing that the government should not
hesitate to carry out public-fund infusions if banks become
undercapitalized as a result of bad-loan disposals. The other new
deputy BOJ governor, Kazumasa Iwata, is a former EPA bureaucrat. When
interviewed by the Nikkei last April, he said that Japan needs to
"create strong economic recovery based on private sector demand," and
that "banks need to cultivate businesses that turn higher profits than
most of their present borrowers do. Structural reform, including
writing off bad debts, would accelerate such a move." Iwata is said to
have close ties with Takenaka, leading some to suspect a move by the
BOJ to strengthen its grip on the banking sector or to lend more
support from the BOJ for Takenaka's "hard landing" approach to the

Better Coordination or Monetary Muddle?
In choosing a trio of career bureaucrats from Japan's three main
financial policy bodies (CEFP, MOF and BOJ), Koizumi has opted to
maintain a balance of power between the ministries and the central
bank. Whether this results in better-coordinated monetary and fiscal
policy remains to be seen. The nominations of the new deputy governors
are an attempt to include a fiscal-policy perspective in the
institution tasked with setting monetary policy. Muto excels at
negotiations, and is an old acquaintance of Fukui's. The Finance
Ministry sees Muto as their "man" on the BOJ Board. Finance minister
Masajuro Shiokawa told reporters, "The inclusion of a former Finance
Ministry bureaucrat in the BOJ leadership will make it easier to
coordinate policy smoothly ... We will see the BOJ as part of Japan's
economic policy." But if Fukui and Muto find themselves at the center
of a power struggle between their respective camps, monetary policy
and the economy will suffer. Like his predecessor Nakahara, Iwata, a
senior Cabinet Office official (i.e., Takenaka's "man"), could add
further policy discord by pushing for more unconventional monetary
policy steps. The test will be whether this diverse team can come up
with viable measures rather than just a hodgepodge of policies. The
only remaining realistic option is for the government and the central
bank to adopt comprehensive policies that encompass both fiscal and
monetary policy.

This would entail, however, that a historically significant "truce" be
forged between the BOJ and the MOF, which have historically had a
habit of mutual finger pointing on the economy. Indeed, the MOF was
the one that demanded that the BOJ adopt the controversial policy of
inflation targeting. Fukui has expressed a willingness to work with
the government in tackling deflation but has stopped short of saying
how far that cooperation would go.

Does a Career BOJ Governor Spell "Sell" For the Stock Market?
Traditionally (at least in postwar Japan) the governorship of the BOJ
has alternated between the BOJ and the MOF, with BOJ governors gaining
the reputation of being bearish for the stock market. Ostensibly this
is because career BOJ governors were less susceptible to pressure from
the LDP and more willing to make the difficult decisions, such as
raising interest rates or trying to deflate the late 1980s asset
bubble, as Yasushi Mieno attempted. But since the excess credit
"bubble" burst in 1990, it doesn't seem to have mattered. Indeed,
Japan's stock market has continued to fall, regardless of which camp
the BOJ governor was from or what sort of monetary policy was taken
(which was invariably an easing one).

The only surprise to the financial markets from the recent BOJ
personnel selections was Muto. Stock market participants are now
hoping that the new board could produce:

1) Increased purchases of stocks from the banks, from 2 trillion yen
to as much as 4 trillion yen.
2) Increased outright purchases of Japanese government bonds (JGBs),
from 1.2 trillion yen to more than 2 trillion yen.

The appointment of the new BOJ governor seems to have reassured
bond-market participants, initially attracting buying on expectations
that he will not significantly change current monetary policy anytime
soon. The selection of Muto prompted speculation that the BOJ may
adopt policies conducive to the market's smooth and steady absorption
of JGBs. Some expected that the long-term interest rate could fall
below the record low of 0.75 percent by the end of March.

Some have expressed the hope that the BOJ might resort to new measures
aimed at supporting share prices over the medium to long term,
including increased purchases of stock from the banks, and the
purchase of exchange-traded funds, but the selections themselves will
have little short-term impact on share prices. While many in the
market are calling for effective anti-deflation measures, some are
concerned that Fukui will be cautious about changing the current
policy. Some investors worry that the BOJ under Fukui's watch might
end up merely reacting to events rather than making a proactive
policy. Thus, stock-market participants are placing more hope on the
new BOJ deputy governors. There is the hope that "their appointment
will make it easier for the government to exert pressure on the BOJ to
take certain measures, and this may become a stock-buying incentive."

In the currency markets, the news of Fukui's appointment sparked yen
buying on expectations that the BOJ will not likely adopt inflation
targeting anytime soon. This dashed hopes for guidance from the BOJ
that would push the yen lower against the dollar.

As for additional policy steps, some believe the new BOJ Board could
move to seriously consider buying other kinds of assets besides
government bonds -- such as overseas bonds or exchange-traded funds.
Such a move would also allow the BOJ to encourage a weaker yen or
higher stock prices, not just supply funds to the market. These
monetary measures from the BOJ could come as part of some new economic
package tied to fresh fiscal measures from the government.

The End Game Remains Structural Reform
MoneyWatch sees no end to the "slow rot" other than putting committed
reformers in charge of vital policymaking institutions. In this
regard, the common thread of the new BOJ governor and deputy governors
is reform. Deflation cannot be cured through monetary easing alone,
and that makes structural reforms more important than ever. Takenaka,
minister for economic policy and financial services, has made it clear
that monetary easing will not suffice without the disposal of bad
debts. During the past several years, Fukui has studiously sought
suggestions from domestic and overseas experts for addressing Japan's
monetary problems. In addition, even his critics acknowledge his
political acumen, flexibility and a dense network of supporters in
politics and business. These assets could make him more effective in
building consensus for action beyond the scope of the BOJ's mandate.

Fluent in English, and conversational in French and German, he seems
to be able to convey a sense of the dilemma facing Japan to his
international peers that has been lacking at times in the past. But as
Takenaka has pointed out, there is no magic wand for Japan. He
believes it will take 5-10 years to see results from the Koizumi
administration's and other reform efforts, with 2003 foreseen as being
an "intensive adjustment period" for structural reform. His economic
scenario is for gradual improvement in economic performance -- and
that's the best-case scenario.

-- Darrel Whitten

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