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Japan's Real Crisis

Cover Story


Until its hidden debt mess is cleared up, no recovery is possible

If only Japan would listen. That sentiment, in one form or another, has been a favorite among foreign governments, executives, and commentators for years. In the 1970s, as the Japanese created the world's most dynamic automobile industry, Americans urged them to curb their exports. When Japan rode a wave of prosperity in the 1980s, Western governments demanded that the country open up its restricted markets. And today, as Japan staggers into recession, finance ministries around the world are begging the government of Prime Minister Ryutaro Hashimoto to spend, spend, spend. Cut taxes, Mr. Hashimoto. Prime the pump by tapping Japan's $10 trillion in savings. Just act, and you can kick off a recovery in Asia that will prevent a global slowdown and end the region's crisis.

In recent weeks, the chorus from the world's moneymen and heads of state has grown louder. Michel Camdessus of the International Monetary Fund, Treasury Secretary Robert Rubin, and Prime Minister Mahathir Mohamad of Malaysia, among others, have called on Japan to act. President Clinton plans to have a stern talk with Hashimoto at the upcoming G-7 conference in Britain. Japan has responded in its grudging fashion, offering tax cuts of $34 billion over two years and making pledges to boost a public-spending program that already dwarfs the U.S. defense budget. The market, which had wanted $120 billion in tax cuts over three years, drove the Nikkei down. The gloom deepened. If Japan would only listen.

Yet the world's leaders may want to consider that their calls for a tax cut represent dangerous wishful thinking. A tax cut to put some life into the economy would certainly give a temporary lift to Japan. Yet fiscal stimulus, however deep, may not do much to resolve the Japanese crisis at this point. The challenges facing Tokyo are far more multifaceted than simply putting more money in the pockets of Japanese consumers. Japan faces a debt trap of its own making that involves the banks, households, and corporations of the whole nation. Japan must dismantle this trap. Otherwise, its struggles could weaken the yen further and destabilize the world economy, forcing other Asian nations to devalue and eventually hurting U.S. exports. A dysfunctional Japan could slow global growth for years.NEW LIGHT. The problem is not just the reported $600 billion in bad loans that plague the nation's banks. It involves hundreds of billions of dollars of debt that lurk off the balance sheets of government bodies and corporations. It includes millions of families struggling to pay off mortgages on houses that have lost 70% of their value. It encompasses billions of dollars in pension liabilities that no one wishes to acknowledge and $700 billion in offshore liabilities of Japan's banks and corporations. The opacity of Japan's accounting compounds the problem, since not even the most skilled financiers can measure the depth of Japan's obligations. And a steady flow of capital to the equity and bond markets of America and Europe could aggravate the crisis.

Taken together, the liabilities cast a new light on the Japanese problem. Despite the country's $800 billion in overseas assets and $200 billion in foreign exchange reserves, Japan's troubles may run a lot deeper than even the pessimists may realize. Perhaps the size of the debt would not matter if the country were growing briskly. Canada, for example, has sizable public debt, but its economy is sound, so concern about these liabilities is minimal. In the U.S., once regulators resolved the savings and loan crisis, the economy rebounded, and many of the problem debts were eventually paid off.

Yet Japan is not growing. Instead, a crisis of confidence has gripped the nation. In the midst of the financial fog, no one in Japan knows the full extent of the problem, no one can predict where the bottom is, no one knows which bank will fold next, and no one can guess whether the market will ever clear. France and Germany have high debt levels and pension crises, too. But no Western nation needs to grapple with the problem of hidden, unmeasured debt in the way Japan does. "The debt is a time bomb," says Clyde Prestowitz, a veteran Japan watcher and president of the Economic Strategy Institute. "The crazy thing is that the Japanese could take care of it, but they aren't doing anything."

Now, analysts and executives are openly talking about what could go wrong. According to Kunji Okue, an analyst at Dresdner Kleinwort Benson, the government is earmarking 46% of its effective tax revenue for servicing the debt. If interest rates rise again, the government's borrowing costs will jump, and its ability to cover expenses would deteriorate. Okue figures that if long-term rates were at 1990 levels of 7% or so, the cost of debt servicing would make it impossible for the government to cover its payroll. The government may also have to handle more debt than it bargains on, since it has made implicit guarantees to cover much of the bad debt in the bank system."DEMORALIZING." This scenario has compelled Moody's Investors Service to put Japan's sovereign debt on Credit Watch. "Japan could become like the Latin American governments of the 1980s, when debt service ate up expenditures," says Moody's senior analyst Thomas Byrne. Although Japan is far richer than the Latins, it has little room left for further tax hikes, which would lead to slower growth and even more deflationary pressure on assets. And to keep capital at home, Japan may have to raise rates, since deregulation makes it easier for Japanese to put their money in investments overseas.

The situation is unstable. Banks dare not lend any more, and corporations are desperate for credit. Yes, Japan is immensely rich, and it can still resolve its crisis, given its deep pool of talented workers, its tradition of sacrifice, and a history of remaking itself. But at this point, its liabilities would strain a country far better governed than it is. "When the economic history of this century is written, one of the great stories will be Japan's mishandling of its own economy," says Jay W. Chai, chief of Itochu International Inc., a subsidiary of the big Japanese trading house. "It's a sad, demoralizing tale."A MONSTER. To get a sense of how bad things are, look at institutions that get little mention in the papers. In Japan, there's a sprawling shadow budget that few outside the country ever hear about. It's called the Fiscal Investment & Loan Program, or Zaito. But it's a monster, with spending that approaches two-thirds of government outlays. Over the years, it has been a stealthy source of financing for favored enterprises of bureaucrats and the Liberal Democratic Party. Funding for the projects has come from Japanese savers, through public pension assets and the vast state-owned Postal Savings system. All told, Zaito's loans come to some $2.8 trillion, all backed by the government. The suspicion is that perhaps 9% of these loans, some $250 billion, are invested in useless projects that aren't generating enough return to pay back the debt.

The shadow Zaito budget, controlled by the Ministry of Finance, steers lending into nearly 50 government-linked entities. These include the National Forest Service, the Japan Development Bank, public companies such as Japan Highway Development Corp. and Japan National Railways, and local governments and special firms such as Kansai International Airport Co., which is underwriting the Osaka airport. Environmental Hygiene Financial Corp. has extended $7.6 billion in loans, mostly to restaurants and bars, for cockroach control and other public-health matters. At least 5% of these loans are in trouble, since many restaurants have folded during the stagnant 1990s.

Zaito also supplies low-interest loans to the Housing Loan Corp. (HLC), which holds 40% of all mortgages. The HLC claims to have only $1.4 billion in questionable loans. Yet that may be understated, given the blowout in the property market and the fate of the jusen, the seven private housing-loan corporations that needed a $6 billion bailout three years ago. Zaito loans are also indirectly propping up many local governments. Kleinwort Benson's Okue thinks a dozen municipalities are effectively bankrupt and rely on Zaito funds to cover debts and payroll.

It's only a matter of time before the problem loans of the localities and the government corporations end up on the central government's books. One big hit will come in October, when the government assumes $213 billion in loans from the now-defunct Japan National Railways Settlement Corp. That was a special outfit set up to manage assets and debts left over from the privatization of Japan Rail in 1987. The plan was to pay off the debts by selling off some of Japan Rail's real estate. Yet when the bubble burst, there weren't many takers, and the debt has lingered. "We already have a debt crisis in the private sector," says Schroders Securities Japan economist Andrew Shipley. "The next bomb that will hit will be a debt crisis in the public sector." Eventually, the central government will have to write this debt off, at a huge cost to taxpayers.

The math gets scary pretty fast. Official statistics already place the gross debt of Japan's central and local governments at about 100% of gross domestic product, or $4.5 trillion. That's one of the highest in the industrialized world. Yet the real debt may equal 250% of Japan's output, or $11 trillion, figures Oxford University's David L. Asher, who co-wrote a study on Japan's debt mess. Asher reaches that number by figuring in liabilities buried in Zaito and other government-controlled corporations, and adding unfunded public-pension obligations, which come to 100% of GDP.

Clearly, the Japanese are masters at running up deficits, and Asher takes a dim view of foreign policymakers who prod Japan to keep spending. "That's like telling a heroin addict to take another fix," he says. Ordinary Japanese and the corporate sector love their debt, too. Corporate balance sheets are burdened with debt levels that run at four times equity, compared with 1.5 times in the U.S. Mitsubishi Motors has $15 billion in debt, four times its equity. It can service that debt only because it has forgiving banks that are tight with the Mitsubishi keiretsu. Meanwhile, Daiwa Research Institute has scanned the data of 24 big companies that list their unfunded pension liabilities. Extrapolating from the data, Daiwa figures 40% of pension plans are underfunded.

Among ordinary consumers, thanks to a 70% meltdown in property prices since 1992, households are probably sitting on $250 billion in paper losses. And amazing as it seems, land prices and the already depressed Nikkei index may have to fall much further before they accurately reflect the true value of property and corporate assets. Such drops could wipe out an additional $3 trillion in wealth, on top of the $10 trillion that already has been vaporized in the past decade. No wonder consumers refuse to spend. "These days, if you have 100,000 yen [$760], you contemplate carefully what to spend the money on," says Yoko Ishikawa, a homemaker and mother of three in the Tokyo suburb of Chiba. "In the past, we would jump on things without giving a careful thought."PIGGY BANKS. These hidden liabilities help explain why Hashimoto and his LDP are wary of tax cuts. Cuts are a sop to the foreign crowd, because few in Japan think tax breaks will boost consumer spending. "Tax breaks aren't as effective as most people think," says LDP Secretary General Koichi Kato. Ordinary Japanese are so anxious about job security, living standards, and retirement that they probably would just save the money from a tax cut. Consumers are already shifting their savings out of banks and into the Postal Savings system, aggravating the problems of private institutions. Judging from the brisk sales of home safes, they also may be lugging suitcases of yen back home. With bank deposits yielding less than 1% in interest, why park your savings in a bank that could go under?

Cash is also disappearing into foreign bonds and equities. Last year, Japanese purchases of overseas equities surged by 77%, to $13 billion, and, save for a collapse of the bull market overseas, the Japanese should keep up that pace in 1998. But if the outflows grow large enough, the yen could weaken to 150 to the dollar, from 130 now.

The impulse to hoard or invest abroad could slowly bring the consumer economy to a stop. Retail sales at department stores are falling by 15% or so a month. "Japanese citizens have the money, but they don't use it because they can't see a future," says outgoing Honda President Nobuhiko Kawamoto. Like other auto makers, Honda is coping with double-digit declines in domestic sales. Meanwhile, personal bankruptcies shot up 21% in 1997, to about 71,299 households. Because of the social stigma of filing, one bankruptcy lawyer, Kenji Utsunomiya, thinks the figure is closer to 500,000.

While consumers stay scared, the banks are unwilling or unable to lend further. Fear is growing that the banks, which have acknowledged $600 billion in sour loans, are sitting on an additional pile of nonperforming assets. Analysts think many small and midsize companies are just not servicing their loans. Companies sometimes cannot collect debts, either. After Shimizu Corp., a big construction outfit, announced a write-off of $360 million in doubtful debt, analysts concluded that other construction companies faced a similar crisis.HARD SLOG. The destructive cycle is reinforcing itself. Many banks are cutting off credit to companies they were once willing to keep afloat. The aggregate debt of bankrupt companies, at 3% of GDP, is higher than the U.S. had during the Great Depression. "This is the worst credit crunch Japan has ever experienced," says Richard Koo, an economist at Nomura Research Institute Ltd. It will get worse. According to some estimates, about $250 billion in loans is technically sound--but only because banks have lowered interest rates to practically zero to keep customers paying. A chunk of these loans could slip into default at any moment, boosting nonperforming loans to an estimated $770 billion.

The tax code is contributing to the crisis. High marginal rates encourage companies to report as little profit as possible. Companies borrow heavily to invest more than they should, so they can get rapid depreciation on the equipment they buy and earn big interest deductions on the loans they take out. This system works fine in a rising economy. But when a crunch comes, the near-total absence of profits turns these companies into debt disasters.

Meanwhile, staggering amounts continue to flow into public works of questionable value. How else to describe a state-funded German-theme park in tropical Okinawa? Or the special roads and airstrips built just for farmers to transport vegetables around Japan? In Fukui Prefecture, the government has spent $346 million to build a harbor to accommodate 5.9 million tons of cargo a year. Today, it's largely empty, and wags call it "the 10 billion-yen fishing pond."A WAY OUT? In the months to come, Japan's recession will show how much damage the dysfunctional economy can inflict on the world. A recent Morgan Stanley Dean Witter & Co. report figures that a recession in Japan will clip 2.5% off the region's GDP. It's time, then, for foreign businesses and policymakers to imagine a global economy in which Japan--the world's biggest creditor and Asia's most important player--spends perhaps a further five years in the wilderness searching for a solution to its problems. That means living with a much weaker yen and securing the global banking system against the shocks of Japanese financial failures.

The Japanese can still work their way out of this trap. But it will take a sustained effort at overhauling the banking sector, letting equity and land markets finally hit bottom, and shaking out a largely unproductive domestic economy that will cause plenty of short-term pain (table). Japan's bureaucrats also need to adjust their world view. For years, the Ministry of Finance has been plotting a strategy to ease Japan into a new era as a pension state. The idea was to supply a graying population with income and security by investing Japan's savings in dynamic economies such as the U.S. and Asia, to make up for slower growth at home.

That strategy is now in tatters with Asia's slump and the domestic debt debacle. Indeed, one big reason policymakers are afraid to write down Japanese assets and debt is that it would wipe away a big chunk of the principal on Japan's retirement savings. Paralysis results.

As Japan seeks a way out, a current TV hit offers insight on the public mood. Every week, millions tune in to watch a historical drama on the downfall of the Tokugawa shogunate in the 19th century. It's the saga of a military dictatorship done in by indecision, rebellious barons, and the threat of U.S. warships off the coast. The costumed actors act out the unraveling of the old feudal order and the rise of modern Japan.

Some commentators suggest the show's popularity is a clue to a public yearning for some sort of event that will do away with the old ways. A few politicians even talk of the need for a great upheaval on the order of the Meiji Restoration of the 1860s, or the arrival of U.S. occupation troops in 1945. Japan certainly has been able to reinvent itself through crisis. But no one seems ready to inflict the kind of shock the country needs now.BY BRIAN BREMNERReturn to top

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