Commentary: The Tsunami Threatening Japan
What if debt-ridden Japan called in the IMF?

Flash forward to 2005. Japan's government debt is clocking in at nearly 200% of gross domestic product, and servicing that load is soaking up 70% of tax revenues. The bond market is in a tailspin, and long-term rates are surging. There's talk of capital controls. Japan is under pressure from the Group of Eight to opt for an International Monetary Fund-style round of draconian budget cuts and an auction of state-owned assets.

Sure, it's a fantasy--for now. Even in the depths of its bank crisis two years ago, no one inside or outside Japan called for an international SWAT team to be sent in. With the Liberal Democratic Party emerging from a bruising national election, the last thing the ruling class wants to do is sound the alarm about Japan again. Instead, LDP elders and Prime Minister Yoshiro Mori are busy proclaiming the start of a recovery. Need the IMF? Like the plague.

TIPPING POINT. But the idea of IMF intervention isn't far-fetched, if Japan's debt levels continue to spiral. The IMF, and Japan for that matter, issued alarms about U.S. deficits in the 1980s and early 1990s. Britain called in the IMF in the worst days of the late 1970s.

And certainly, some outside scrutiny of Japan's true state would reveal frightening truths. The biggest: Japan is closer to a tipping point, where it could slide into financial crisis, than anyone wants to admit. If that happened, the global turmoil would be huge. A fast-falling yen would bring down other currencies in Asia. The greenback would soar, hurting U.S. exports. Already, new alarm bells are sounding: Moody's Investors Service is considering downgrading Japan's debt unless Tokyo comes up with a convincing plan to reduce its mounting liabilities. Even the Ministry of Finance concedes that with 1.75% or so annual growth, Japan simply cannot grow its way out of the problem without a fiscal overhaul.

So let's indulge the conceit for the moment that in the not-too-distant future, the Japanese government quietly invites IMF investigators in to examine the books and plot a way out. What would these sleuths discover? For starters, they would quickly establish that Japan does not have the same crisis that brought down Thailand, Indonesia, and South Korea. Those countries had borrowed recklessly in dollars from abroad. The Japanese government, in contrast, has been borrowing mostly from its own citizens.

But these conditions, the IMF sleuths would find, provide a false sense of security. Years of pump-priming, bank bailouts, and a shrinking tax base have pushed Japan from a 3% budget surplus in 1993 to a 10% deficit now. The combined central and local government debt load will hit 140% of gross domestic product, or $6 trillion, this year. Debt-servicing costs are absorbing 65% of what's left of central government revenues after mandatory transfers to local governments. No wonder Goldman Sachs Asia Vice-Chairman Kenneth S. Courtis calls it the ''biggest capital shift by any economy in peacetime,'' dwarfing the budget-busting Reagan defense buildup and German reunification.

Worse, in our fantasy scenario, once the sleuths opened the books, they would find that even government estimates forecast Japan's total debt load hitting 180% of GDP by 2005, without drastic spending cuts. Private estimates peg the debt to rise even higher. Every percentage-point increase in rates would add $7.7 billion to the $100 billion it already pays in interest annually.

These numbers would make the IMF investigators break out in a cold sweat. The debt shock would probably be transmitted through Japan's huge bond market, sending rates soaring and driving government finances to the danger point. Indeed, unless things change fast, Courtis thinks another financial crisis in Tokyo could come in the next year or so. And Massachusetts Institute of Technology Japan specialist David L. Asher foresees a ''financial Mt. Fuji'' eruption that dwarfs past upheavals such as Mexico and East Asia.

But what can be done? That's where our IMF team's ingenuity would be taxed. Despite all the pump-priming, ordinary Japanese haven't spent, because they know Japan's debt mess holds out the promise of future tax hikes and spending cuts. ''They have taken a defensive stance,'' says Bank of Japan Policy Board member and former IMF economist Taizo Taya. So the IMF planners would have to look for a way out of an impossible situation. Perhaps they would tap the expertise of outside observers. One who has thought long and hard about Japan's plight is MIT's Asher. His recommendations make a lot of sense.

One would be a five-year moratorium on nonessential public works. Japan spends 20% of its budget on this stuff, three times the level of the U.S., Germany, and France. Such a move would be a shock to many construction companies, which employ 6 million workers, but it would make more capital available to private enterprise to invest in the economy. Of course, deficit spending should continue, say Asher, Courtis, and others: But it would support and retrain displaced workers, not pay for new roads.

Economists realize this plan would only work if Tokyo got serious about enforcing the tax code. Asher recommends a crackdown on massive tax dodging: More than 60% of Japanese companies pay no tax, some because of losses but many others because of simple evasion.

Asher says some supply-side measures will be needed: a two-year tax holiday for home purchases, and the abolition of a punishing capital gains tax on land transactions. The national pension plan would have to shift to private alternatives. And Asher suggests rolling over the national debt to long-term zero-coupon bonds to give Tokyo more breathing room. Savers would scream, but the alternative of never-ending economic stagnation isn't much fun either.

LACK OF POLITICAL WILL. Meanwhile, Japan's banks, laden with bad debt, would have to hand over the sour loans to a public institution, which would swap the loans for equity in the borrowers', then sell the new equity cheaply on the market.

These are hugely ambitious ideas, but at least they go to the heart of Japan's problems. Yet they do not tackle the issue of political will. Though some Japanese politicians want fiscal reconstruction, not one is calling for anything as sweeping as what's needed. Most hope to muddle through. And that's why an IMF intervention in the world's second-largest economy may not seem such a mind-bender.

By Brian Bremner
Bureau chief Bremner covers Japanese finance from Tokyo.

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Commentary: The Tsunami Threatening Japan

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