MW-23 -- Baghdad in 17 Days

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Weekly Financial Commentary from Tokyo

Issue No. 23
Tuesday, April 8, 2003

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Viewpoint: Baghdad in 17 Days

The Bottom Line:

o Who was right? By day 17 of the Iraq War, the "coalition
forces" were on Saddam's doorstep in Baghdad, much to the
surprise of critics who suspected that the invasion would get
bogged down by unconventional tactics and insufficient

o The most accurate measures of how the war would affect
financial markets have been oil and gold prices. Both were
acting like the results of the war were a foregone conclusion
even before the general press began reporting the "good news"
that the war would not be as protracted as some feared. As we
pointed out in Money Watch #21, the "war premiums" in both of
these markets have now essentially evaporated, and these
markets should now be driven primarily by supply-demand
factors that existed prior to the war.

o The situation in the equity markets is a bit more complicated,
especially with regards to the Japanese equity market. This
notwithstanding, we see the potential for a tradable rally
(again as we pointed out in Money Watch #21) partly because
the Japanese government has overreacted to the Iraq War,
partly because the supply-demand picture should brighten in
the first quarter of the new fiscal year, and partly because
the Band-Aids put in place by the Japanese government to avert
a "March crisis" and to insulate Japan's market from negative
fallout from the Iraq War will not become effective until the
first quarter of the new fiscal year.

o However, the policy backsliding on reform recently being shown
by the Japanese government will only make their fundamental
problems worse. Thus the structural bear market in Japanese
equities is far from over; simply because the Japanese
government, despite Mr. Koizumi's claims otherwise, continues
to "take the low road" to solving Japan's structural problems
-- and these low road solutions only bring them farther down
the road to a fiscal and/or a financial crisis of "Great
Depression" proportions.

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Baghdad in 17 Days
Who Was Right?
As CNN carried live video of Bradley fighting vehicles racing across
the desert into Iraq, the media and the markets somehow got the idea
that the Iraq war would be a cakewalk. Some war boosters had indeed
predicted that Iraq's leadership would snap, Iraqi forces would
surrender and Iraqi citizens would welcome American soldiers with open
arms. But at the end of the first week's fighting, reality seemed to
be much different than these expectations, and the media as well as
some experts were asserting that the US was not prepared for the
possible difficulties. Iraqis appeared to be resisting vigorously in
ways that seem to have caught the Pentagon off guard -- that is, by
embedding paramilitary forces behind the front lines to engage in
guerrilla tactics that couldn't win the war but could dangerously drag
it out. Pentagon officials were telling reporters that they thought
they had underestimated the strength and capability of Iraq's
paramilitaries. In addition, freed Iraqis were not exactly dancing for
joy from the very first days of the war. Then there was the lull in
fighting and reports that troops on the front lines had only one day's
rations. When US-led forces were within 49 miles of Baghdad, critics
contended that they were getting bogged down on the way to the Iraqi
capital in the face of unexpected resistance.

But then, as doubts about the war were approaching a feverish pitch,
news broke that a Special Forces team had rescued POW Army Pfc.
Jessica Lynch in a daring raid on an Iraqi hospital. Perceptions of
the war began to turn. By Friday, the US was already securing Baghdad
airport and sending sorties into Baghdad itself. In short, US forces
were in Baghdad in just 17 days. Suddenly, all the talk of
insufficient force numbers, a hiatus of up to a couple of weeks before
reinforcements arrived, and of a long, messy battle with Saddam
Hussein's Republican Guard was silenced. When US troops attacked the
airport, some 2,500 Iraqi Republican Guards reportedly surrendered,
while there were reports of large numbers of Iraqi military and Baath
Party officials slipping their trucks into civilian caravans of cars
leaving Baghdad. Suddenly, General Tommy Franks and his superiors at
the Pentagon were looking more right than their detractors, and it
looked like Secretary of Defense Donald Rumsfeld, who had initially
stated that "it (the Iraq War) could last six days, or six weeks, but
I doubt six months," had been basically correct in his original

Perception of the Financial Markets
The two markets that have been the purest proxies for market sentiment
regarding progress of the Iraq War were oil prices and gold prices.
Brent crude futures prices have plunged 31 percent since peaking on
March 14, 2003, and look to be testing recent downside resistance,
after surging by 53 percent from a trough in mid-November of 2002.
Gold, which had already been rallying because of the sell-off in the
dollar, had already peaked in early February 2003, up 24 percent from
lows seen in late October 2002, and have since fallen by 16 percent
from this peak.

Both of these markets appear to have already deflated the "war
premium" that had been built into market prices with the build-up to
the Iraq War. While there may still be a few "war premium" twitches,
price formation in these markets will now be largely determined by the
underlying supply-demand conditions that existed prior to the onset of
the Iraq War.

For the equity markets, the situation is a little more complicated.
The lead up to the Iraq War created a "war discount" in stock prices
-- the opposite of what happened in the markets for oil and gold. For
the US, the impact was twofold. First, there was the negative impact
that the war was having on the dollar, and then there was the impact
uncertainties about the war were having on investor perceptions of
economic growth and corporate profits. Global equity markets were in a
bear phase when the Iraq War hit.

The Dow Jones industrial average has been trying to rally since the
onset of the Iraq War, from a low of 7,397 hit on March 12, a week
before the war began, to a high of 8,552 on March 21, after the war
began on March 19. Subsequently, the US market sold off on doubts
about how quickly and painlessly the war could be concluded, but the
Dow Jones index remains in a basic up-trend. In Money Watch #21, we
flatly stated that, historically speaking, the onset of war was good
for stocks. The second week of the war had this prediction looking
pretty iffy. Would history fail to repeat (or at least rhyme) and
would this time prove different? Subsequent events, however, are
indicating that, true to historical experience, the Iraq War will
indeed be good for stocks.

Overreaction by Japan?
In retrospect, the "extraordinary measures" mindset that developed in
the Bank of Japan and the Japanese government partially because of the
Iraq War will prove to be an overreaction, much like the overreaction
to the bogus Y2K problem. But more is at work behind the political
scenes in Japan than just this overreaction to the Iraq War. That is,
the newfound "flexibility" within the Koizumi administration is the
result of prime minister Junichiro Koizumi's falling popularity in the
polls. Koizumi's star has been on the decline for several months.
Since the onset of the year, he has taken quite a beating on the TV
talk shows, and in the past month the press has jumped on the "Koizumi
bashing" bandwagon. One economic commentator flatly stated that the
Japanese stock market would rally by 2,000 points if Koizumi were to

As his approval ratings have fallen from the high 80s to the low 40s
(and his disapproval ratings have risen accordingly), Koizumi has lost
his political Teflon and is ever more exposed to criticism from within
his own party. This has resulted in a much more flexible (i.e.,
compromising) attitude within his cabinet, which itself has been
plagued with political scandals. This is nowhere more visible than in
the Financial Services Agency (FSA), whose grand "Financial Revival
Plan" continues to be watered down by infighting from within the
Liberal Democratic Party. An apt example of this is in the March 26
issue of the Nihon Keizai Shimbun, which carried a front-page headline
entitled, "Banks Gain Reprieve from Nationalization." The FSA has
backed off its promise to convert the preferred shares that the
government owns in the major banks and instead has stated that it
would not convert major bank shares into voting common shares if the
banks can pay a dividend in one of the next two years. In addition,
the agency has established a separate supervisory framework for the
regional banks than that ostensibly applied to the major banks in the
Financial Revival Program. Instead of "putting the pedal to the metal"
on reforms, the government has introduced yet another set of
"procrastination policies" for the banking sector.

More Band-Aids for Japanese Stocks
Under fire for his reform policies on several fronts, Koizumi on the
surface continues to resist calls for more fiscal stimulus. His
primary breakwater for these growing waves of criticism is apparently
the new Bank of Japan governor. It is highly likely that governor
Toshihiko Fukui already struck a deal with the Koizumi administration
before he was confirmed as the next BOJ governor. Fukui reportedly met
with Koizumi on March 14. At the meeting, Koizumi reportedly read and
then handed Fukui a set of five requests from the administration:

1. The administration's high expectations for effective
monetary policies that will work to eradicate deflation by

2. A request for the BOJ to work in close communication with
the Finance Ministry in implementing "appropriate" foreign
exchange policies,

3. Cooperation from the BOJ in promoting accelerated disposal
of nonperforming loans,

4. A promise from the BOJ to "openly exchange" views with the
administration, and

5. A tacit agreement from the BOJ that it would work to ensure
the proper response to financial and economic conditions.

As regards the first request, it is possible that inflation targeting
will be considered. As for the second request, measures to defend
against a strong yen and the purchase of foreign bonds are two
possibilities. As for the third request, it is conceivable that
purchases of nonperforming loans at their real book values will be
considered. The fourth request refers to the so-called "government-BOJ
accord" that had been described during the search for a new BOJ
governor, and number five can be interpreted to mean that the BOJ
should be willing to consider countermeasures outside the boundaries
of conventional monetary policy.

Finally, preparations for the start of the Industrial Revitalization
Corp. (IRC) are proceeding more or less smoothly; it should be
approved and fully functional after the Golden Week holidays. The new
president, Atsushi Saito (formerly of Nomura Securities) was a huge
hit at a recent Diet testimony, where he gave a de facto policy speech
outlining how he planned to run the IRC. He was such a hit that some
opposition politicians commented that "he should become prime

Tradable Rally in April-June?
In Money Watch #21, we suggested that the Japanese stock market was
due for a tradable rally (as opposed to a fundamental shift in the
ongoing bear market). The ongoing unwinding of corporate pension-fund
positions as corporations return the management of their national
welfare pension funds back to the government could exert downward
pressure on the market from the onset of the new fiscal year, but the
BOJ has upped its purchases of stocks from the major banks from 2
trillion yen to 3 trillion yen, implying that the combination of these
two factors could be a wash.

In addition, as the major banks have survived the "March crisis" hump,
their unwinding of equity positions is expected to take on a much less
urgent tone, while the Government Pension Investment Fund has
allocated 1.7 trillion yen in new funds to Japanese equities in the
new year. Provided that it becomes increasingly clear that the Iraq
War is winding down, it is likely that foreign investors will also be
more inclined to take another punt on the Japanese market,
particularly as the yen continues to trade firm against
the dollar.

Finally, there are the policy Band-Aids that policy makers belatedly
put in place in the heat of concern about a "March crisis" and the
Iraq War. Should the central bank begin making more obvious gestures
to consider and even implement more wide-ranging asset purchases (such
as exchange traded funds, foreign bonds and the like), this will
undoubtedly be taken as a positive by the stock market.

Fundamentally, however, the backsliding in bank reform efforts merely
prolongs the banks' plight and does nothing to restore confidence in
the banking system, thereby having little lasting impact on
eradicating deflation and on fixing Japan's economy. As pointed out by
RIETI fellow Keiichiro Kobayashi (Miyakodayori, March 28, 2003), since
the 1990s, additional increases in the high-powered money supplied by
the BOJ have been producing less and less of an impact on the money
multiplier (M2+CD). In the 1990s, cash increases have flowed out of
the banks into nonfinancial firms, a clear indication of loss of trust
in bank deposits. But where an increase in M2 (deposit liabilities) is
shown on bank balance sheets, a decline in cash is offset by a decline
in securities holdings, while lending shows no marked decrease. This
indicates that the banks should not be accused of causing deflation by
not lending. However, their weak balance sheets have led to a loss of
trust by savers.

The conclusion is that a recapitalization of the major banks could
help stem deflation. A study by John Boyd of University of Minnesota
and Bruce Smith of University of Texas-Austin showed that shoring up
bank capital could help restore depositor confidence, in turn leading
to increased deposits, which in turn leads to increases in M2, thereby
alleviating deflation. According to the study, every 1 percentage
point of GDP that is used in revitalizing the banking system by
liquidating failed banks and recapitalizing other banks produces a 5
percentage point change in the rate of M2.

While not as clearly or simply described, this is probably the precept
upon which FSA minister Heizo Takenaka and the former BOJ governor
based their views that the major banks needed to be recapitalized. But
pressure on the banks from the BOJ and the FSA only produced a
virulent backlash from the banks and their supporters within the LDP
to the point that Takenaka was forced to back away and the BOJ
governor retired in favor of a new, "more flexible" governor.

If the political difficulties in injecting public funds into the
Japanese banks could be ignored, deflation could be solved by
injections of public funds. The exit strategy for the government would
be to sell off its bank holdings once trust in the banking system had
been restored. Thus the ostensible prognosis for fixing the banking
system *and* curing deflation is to inject public funds and have the
BOJ finance the policy with purchases of Japanese government bonds.

However, the downside would be a short-term deterioration in public
debt, commensurate to the scale of funds needed to revitalize the
banking sector. It is thus a mistake to assume that reflation can be
accomplished without further fiscal burden, which is the direction
currently being indicated by the present policy debate.

While the real question to ask under such a policy regime would be "at
what point does the fiscal burden have to increase to cause a fiscal
crisis," Boyd and Smith have demonstrated with examples from other
countries that trying to solve banking problems with inflation has
inevitably led to repeated bouts of problem loans and banking crises.

Thus "inflation targeting" or other "artificial" efforts to rekindle
inflation are only a transitory solution. Federal Reserve governor
Donald Kohn, in remarks released on the Federal Reserve's home page,
has also expressed his doubts about the effectiveness of inflation
targeting, because the benefits of inflation targeting can often be
outweighed by the costs of such a program.

The bottom line is that, while we may see a tradable rally in the
Japanese stock market over the next several months, the structural
bear market in Japanese equities is far from over simply because the
Japanese government, despite Koizumi's insistence, continues to "take
the low road" to solving its structural problems, and these low road
solutions only bring them further down the road to a fiscal and/or a
financial crisis of "Great Depression" proportions.

-- Darrel Whitten

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Written by Darrel Whitten

Edited by J@pan Inc staff (


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