MW-24 -- Whither Reform Post Koizumi?

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Tuesday, April 17, 2003

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Viewpoint: Whither Reform Post Koizumi?

The Bottom Line:

o Contrarians have long been trying to make a case for Japan,
and it remains very much against the consensus to have a
positive view on Japan. But contrarian bets only work if the
direction changes, i.e., if what has been causing the malaise
plays itself out, and the secular trend begins to reverse. The
further condition is that this change of direction has to be
perceived by investors.

o The Japanese voting public has become increasingly despairing
of not only the LDP but also other main political parties as
the Heisei Malaise drags on. In short, they are desperately
seeking a real "hero" and are politically susceptible to
anyone who exhibits even temporary hero-like qualities. While
still Japan's best hope for lasting reform, PM Koizumi is
looking less and less like the man who will be able to deliver
on these expectations.

o Mr. Koizumi's best hope for a recovery in popularity and a
better-than-even chance of surviving past September is the
Industrial Revival Corporation (IRC) and the new Bank of Japan
governor. But it has been Money Watch's contention from the
onset that the IRC was being set up to fail. Meanwhile, the
Koizumi government could well prove politically unable to
deliver its end of the "government-BOJ accord," potentially
leaving Mr. Fukui and his increasingly unconventional monetary
policies high and dry.

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Whither Reform Post Koizumi?
The Japan Market Has the Contrarians and Reformists for Lunch

The Nikkei index closed fiscal 2002 on March 31 at 7,972.71, the
lowest close in 21 years, after falling 27.6 percent for the year and
wiping out another 70 trillion yen of market capitalization.
Conversely, the current 10-year Japanese government bond yield has
fallen to below 0.7 percent. Since real 10-year bond yields have
averaged 2.5-3.0 percent over the long term, a 0.7 percent yield
implies that consumer prices are expected to deflate nearly 2 percent
per annum for the next 10 years. Foreign investors (and even the
International Monetary Fund) wonder how long Japan can continue
lurching from mini-crisis to mini-crisis without triggering a
catharsis-like event or a political revolution.

Contrarians have long been trying to make a case for Japan, and it
remains very much against the consensus to have a positive view on
Japan. The Heisei Malaise has been marked by mind-numbing, capital
destruction. The contrarians have been waiting for a bond market
"bubble" of historical portions to "pop." But contrarian bets only
work if the direction changes, i.e., if what has been causing the
malaise plays itself out, or an event or a series of events provides a
catharsis that causes the secular trend to reverse. The further
condition is that this change of direction generally must be perceived
as such by investors. Even when major secular trends bottom and begin
to reverse, it could be years before investors realize what is
happening. When the US market first began its historical bull run in
the early 1980s, investors were still worrying about "twin deficits,"
structural weakness in the dollar and "double dip" recessions.

We Need a Hero
But then someone came along who actually tried a different approach.
Someone who helped restore American (and British) confidence in their
own future, someone who tried to shrink government and let
entrepreneurial spirit lead the way; someone whose proposed policies
at the time were dismissed as "voodoo" economics. They were not Nobel
prize-winning economists, nor were they financial geniuses, but they
had a very clear vision of what needed to be done and were politically
effective enough to actually get most of what they envisioned into
policy. These "someones" were of course Ronald Reagan and Margaret
Thatcher. In their own right, Mikhail Gorbachev and Boris Yeltsin were
just as influential to the Soviet Union. They both helped to unleash
the forces of capitalism in Russia, and the creative destruction in
Russia made what the US went through in the 1980s look like a picnic.
It was people like Ronald Reagan in the US, Margaret Thatcher in
Britain, and Mikhail Gorbachev in Russia who set the stage for a major
renaissance of "laissez faire" capitalism in the 1990s.

Japan has had glimmers of such "someones" on several occasions over
the past decade. First there was Morihiro Hosokawa, who bolted from
the Liberal Democratic Party in 1992 and founded the reformist Japan
New Party that formed a coalition with the opposition and triumphed in
the 1993 election, thereby ending 38 years of LDP single-party rule.
Although Hosokawa won passage of corruption-reducing electoral reforms
in 1994,these reforms have done little to abate the steady stream of
political scandals emanating from the Japanese Diet since. Moreover,
his main thrust was political reform, as Japan had not yet come to
realize in 1994 that its economy had serious structural difficulties.
Hosokawa then had to resign because of monetary improprieties.

Then came Ryutaro Hashimoto. As prime minister, Hashimoto ostensibly
devoted his energies to six areas of domestic reform: administrative,
fiscal structure, social security, economic structure, the financial
system and education. Money Watch cannot immediately think of any of
these "reforms" that had a lasting effect on eradicating the Heisei
Malaise. Indeed, Hashimoto was more notorious for his ill-timed
introduction of the value-added tax and the premature "big bang" in
Japanese financial services. Ironically, he is now considered one of
the key opponents to prime minister Junichiro Koizumi's "reforms."

Finally, there is Koizumi. Taking the LDP by storm on a tsunami of
public popularity, Koizumi did not promise a chicken in every pot as
his LDP predecessors were wont to do. Instead, he openly talked of
turning Japan's entrenched government administration on its head and
pushing through an aggressive program of reforms in his famous "pain
before gain" platform. His popularity temporarily achieved near
rock-star proportions.

Public to Koizumi: Show Us
The Japanese voting public has become increasingly despairing of not
only the LDP but also other main political parties as the Heisei
Malaise drags on. They are disgusted by the political gridlock that
never seems to achieve any lasting progress, they are fearful for
their jobs, and they have no confidence in their own or Japan's
future. In short, they are desperately seeking a real hero and are
latching on to anyone who exhibits even temporary hero-like qualities,
be it Hosokawa, Hashimoto or Koizumi. Koizumi parlayed this desire
into a phenomenal 86.3 percent voter support rating when he first
chose his new cabinet. He was hailed as Japan's great hope, one who
was willing to stare down the powerful and the entrenched, even within
his own party. But the public is beginning to suspect that in
Koizumi's "no pain, no gain" reform programs, the voting public gets
squeezed unfairly while the so-called perpetrators continue to survive
on the government and the banking sector's dole. He is backtracking on
the reform platform that got him in office and is further distancing
himself from the voting public through sometimes callous and misguided

His popularity was already dropping sharply last May when media polls
first showed a crossover between those supporting and not supporting
the Koizumi administration. More importantly, a Kyodo survey showed
that 80.2 percent of the respondents did not expect Koizumi's cabinet
to last more than another six months to a year. The prime minister was
able to rescue the situation somewhat with a quick trip to North Korea
that resulted in the freeing of kidnapped Japanese, but his opponents
continue to steadily encircle his administration and increasingly
frustrate his reform initiatives.

As his popularity wanes, he and his cabinet are becoming entrapped by
opposition within and without his party to the point that there are
doubts about his ability to survive as prime minister after September.
Opponents have been emboldened, as his once unassailable popularity
with the voting public is now looking very vulnerable.

Reform Initiatives Slow to a Crawl
Money Watch never ceases to be amazed at the government's ability to
shoot itself in its foot as policies previously implemented come back
to haunt them in unseen ways. The "big bang" banking reforms are a
case in point. While ostensibly dramatically liberalizing Japan's
financial services sector, they failed to ensure that any dramatic
deterioration of the health in large financial institutions did not
threaten the very viability of the financial system itself. In short,
they forget to install a safety net for the financial system. It was
not until nearly a year after a near meltdown that such a safety net
came into being.

Another example is the recent change in the pension laws that allowed
companies to return the Welfare Pension portion of employee pension
funds to the government, but which failed to allow companies to merely
transfer the stock instead of having to liquidate the portfolio before
the transfer can be made. As could have been predicted, there has been
significant selling of stock held in these portfolios. So what does
the government do? Coerce the Bank of Japan into buying stocks from
the banks, while attempting to squeeze short sellers out of the
market. Wouldn't it have been easier to just allow the corporations to
transfer the stock instead of the cash?

Then there is the requirement that the banks reduce their holdings of
stock to within their regulatory capital by September 2004. The Mizuho
Financial Services Group alone have reduced its holdings of stock from
9 trillion yen when Fuji, Dai-Ichi Kangyo Bank and the Industrial Bank
of Japan first merged to around 3 trillion yen, representing selling
pressure of a whopping 6 trillion yen. Yet the Bank Equity Purchasing
Corp. that was supposed to soak up this excess supply has been largely
ineffective because of the requirement that the banks themselves put
up capital to insure against secondary losses. Did they not think that
other market participants, seeing this overhang of supply, might also
exacerbate the sell off by selling short or loaning their stock to
hedge funds so they could sell short? Instead, the government blames
market "speculators," and finds itself having to scramble for measures
to artificially support the stock market and slowly but surely back
away from the more stringent banking sector reforms.

Koizumi's best hope for a recovery in popularity and a better-than-
even chance of surviving past September is the Industrial Revival
Corp. (IRC) and the new Bank of Japan governor. From the onset, Money
Watch has suspected that the IRC was being set up to fail. Moreover,
Koizumi may not even be able to take the credit if the IRC does
function as designed, because it wasn't his idea, nor Heizo
Takenaka's. On the other hand, while Toshihiko Fukui of the BOJ
probably has more credibility at this point than the entire Koizumi
administration combined, he is already beginning to trade off of this
credibility with increasingly "iffy" asset purchases that will in all
likelihood not be reciprocated with coordinated government policies,
thereby working to undermine the already doubtful impact of these
unconventional policies. The weakened Koizumi government could well
prove politically unable to deliver its end of the "government-BOJ
accord" it so badly wanted to establish with the central bank,
potentially leaving Fukui and his increasingly unconventional monetary
policies high and dry.

Up until now, Koizumi's "ace in the hole" had been his prerogative to
dissolve both houses of the Diet and call a general election. Under
the current circumstances, his ace in the hole is looking less and
less like an ace and more and more like a joker. The LDP powerbrokers
have been plotting a post-Koizumi strategy for months.

But whither reforms post Koizumi? Half-baked reforms and
restructuring, far from providing the economic stimulus as envisioned,
have only exacerbated the short-term pain. They have not brought
increased spending, but actually the reverse. In the meantime, they
have also significantly exacerbated Japan's debt position. Finally,
Koizumi has presided over one of the most dramatic destructions of
investor capital in modern history. This is the "pain" promised by
Koizumi. But if Koizumi and his administration are in their last days,
we will never get to see if their grand design for future "gains" was
really achievable and could well see more of the "policy backlash"
that we are already beginning to see as Koizumi's popularity wanes.

-- Darrel Whitten

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Written by Darrel Whitten

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