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Commentary: Memo to Koizumi


Dear Mr. Prime Minister: According to the papers, you're off in the mountains recovering your strength after your July election victory. You'll need it. You now have the popular mandate you said you needed to launch your economic recovery plan, which, as you've outlined it, promises to be a sort of national root canal. And you've bravely set as your first order of business an immensely important project: fixing Japan's crippled banks.

The core of your idea is to make 10 major banks write off $100 billion of their nonperforming loans in the next three years, something you claim is possible without a government bailout. You have promised strict monitoring of workouts to keep the process moving. Everyone knows that Junichiro Koizumi is Japan's No. 1 hard-nosed realist. Surely you know that a cleanup of that magnitude will barely make a dent in the country's bad loans. You have to do more. The economy needs a watershed event: a speedy, credible workout in which banks seize collateral and cut off deadbeats.

Time is short. The Nikkei stock index hit a 17-year low on Aug. 20, a body blow for banks, which have much of their capital in shares. New accounting rules will force them to value those shares at market prices and subtract part of the unrealized losses from their capital base when they close their half-year books on Sept. 28. Barclays Capital credit analyst Jason Rogers figures that at current market levels, Japanese lenders have $15 billion of unrealized losses. That will hurt weak lenders such as Daiwa Bank, Chuo Mitsui Trust & Banking, and Asahi Bank. You've no doubt heard rumors of a reprise of 1998, when market panic sunk Long Term Credit Bank of Japan and Nippon Credit Bank.

On Sept. 1, Financial Services Agency Minister Hakuo Yanagisawa will head to Washington to convince skeptics in the Bush Administration, at the International Monetary Fund, and in the financial world that everything will be fine. I agree that the banking system isn't collapsing, though smaller lenders and regional banks are in trouble. The $50 billion the government gave the big ones in 1999 put their capital-adequacy ratios above the minimum 8% threshold. And the government replenished the deposit insurance fund and shut down or merged smaller lenders. Also, Japanese banks actually earn an aggregate $25 billion a year in operating profits--money they make mostly from trading and fees--and have already reserved some $50 billion against acknowledged bad debts.

But the market has good reason to be skittish. The only thing that will calm it is a more daring policy, Mr. Koizumi. Japan's banks, large and small, hold $285 billion or so of nonperforming loans that aren't covered by provisions. Then there is the wild card: some $700 billion worth of so-called classified credits--basically shaky loans. Granted, not all will sour. Yet why be optimistic? Standard & Poor's Corp. bank analyst Takamasa Yamaoka says that $26 billion in debt went bad in the six months ending in March. There may be more "given the fact that the domestic economy has started to deteriorate again," he frets.

Bank analysts are a pain--but they have a point when they say Japan's real dud-loan burden falls between $600 billion and nearly $1 trillion. You know that a vast majority of Japanese banks--most of them local or regional operations saddled with bad real estate as collateral--lack the capital and earning power to handle years of aggressive write-offs. Yanagisawa says "it is inconceivable to me to see a [government] capital injection at this time." That's a noble sentiment. Realistically, the banks will need public cash to replenish their capital after the purge and start growing again.

This is going to be a tough sell to the public. As Yanagisawa rightly points out, another $50 billion injection would stink of the old syndrome of bailouts and lax oversight that created this mess in the first place. Your reformist credentials would be torn to bits. It would sweeten the pill if you pressed bank executives who haven't restructured since the bailout to resign.

But admit it. You're already giving the banks government money in an ineffective way. Having your economic team lean on the Bank of Japan to pump more liquidity into the banking system wasn't wise. The BOJ's surprise decision on Aug. 14 to buy $5 billion more in bonds each month from the banks baffled the markets. The banks are stuffed with cash that they can't lend because few borrowers are creditworthy, and those that are won't borrow in a deflationary economy.

A better use of government resources would be to turn Japan's anemic Resolution & Collection Corp. into your secret weapon. Since 1999, the RCC has spent $8 billion buying up bad loans at an average 4% of their face value. Have Japan's Deposit Insurance Corp., which runs the RCC, issue new bonds--it could take as much as $100 billion over time--to give it the ammunition to buy bad loans in volume. The BOJ could always serve as a buyer of last resort. Next, let the RCC pay more than market value for the loans. This is key because the RCC's problem--along with its tiny budget--is that it drives such a hard bargain that the banks won't sell their loans because the write-offs are huge. If the government absorbed half the losses, the banks would probably be willing to take a haircut on the rest. The RCC would sell the collateral--generally land--or hold it until the economy recovers. That would also start the process of clearing the deadwood from the real estate market.

NATURAL FORCES. Nikko Salomon Smith Barney economist Jeffrey Young thinks it would probably take five years to clean up the banks and would cost them and the public each about $100 billion. This $200 billion effort would rid the banks of the lion's share of the $285 billion of nonperforming loans floating around the system.

And what of that $700 billion in debt that is on the verge of turning sour? With any luck, clearing the worst away would bring natural economic forces into play. Surviving companies would be more profitable without competition from weak companies on life support--especially in crowded fields such as construction and retailing. A Japanese economy growing in the 2% range by 2004 or so would keep the bulk of those loans from turning bad.

That's the theory, anyway. Look, you said that part of your grand plan was to have the RCC play a bigger role. Well, have your people chat up William Seidman, former chairman of the U.S. Resolution Trust Corp., who is coming to Tokyo next month to offer his advice. True, Japan faces a far bigger task than the savings and loan workout Seidman oversaw. But he has looked the beast in the face and defanged it.

Mr. Prime Minister, think about your options carefully. If you can get Japan out of this rut, you'll have earned a mountain holiday--on the financial equivalent of Mt. Olympus.

Sincerely,

Brian Bremner Bremner follows finance from Tokyo.


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