Commentary: Japan's Deflation Is the Real Danger

By Brian Bremner

What ails Japan? Take your pick: a debased currency, a floundering stock market, mountainous government debt, a seized-up banking system, price deflation not seen in a major industrialized country since the 1930s. The list is so long and frightening that there's talk of a financial meltdown by April that will rock global markets and whack an already troubled world economy.

Yet it's wise to differentiate between the idiot chatter in the markets and the real risk of a crash in Japan. The highly visible threats posed by dysfunctional banks and the sliding yen may not hold the most danger. Instead, the more subtle threat of interminable deflation, grinding on month after month, may be the biggest threat, since there's no apparent solution for quickly reversing the years of falling prices.

To see where the real dangers lie, it's best to understand each of the beasts that stalk the Japanese economy. Here's a primer on the biggest Japanese financial risks circa early 2002:

APOCALYPSE NOW. John H. Makin, an economist at the American Enterprise Institute in Washington, has just published a paper, "Japan in Depression," that reads like the really scary passages in the Book of Revelations. His scenario begins on Apr. 1, when the government will rescind the 100% guarantee on bank deposits it made back in 1998 after several banks and brokers collapsed. Fully aware that Japan's banks are saddled with $1 trillion in bad loans, depositors will rush to yank out savings in a run that will bring down one or two of the country's bigger banks. "There will be a full-scale run on the banks," he says.

To prop up the banks, Japan will have to issue a huge amount in new government bonds, meaning that its already runaway public debt, clocking nearly 140% of gross domestic product, will jump even higher. The Nikkei will collapse, and so will the bond market and the yen. There will be widespread capital flight out of yen assets by global investors as the yen's value blows past 150 to the dollar and quickly loses value against other currencies in the region as well, robbing growth from other Asian countries.

Scary? There's more. Economists note several parallels to the 1997-98 crisis that saw the downfall of Yamaichi Securities Co. and three big banks. The yen has fallen 13% since September and is hovering at 134 to the greenback, not that far off of an August, 1998, low of 144. Intensive short-selling has driven the Topix Bank Index down 40% since last March, just shy of the 50% it fell before Long Term Credit Bank and Nippon Credit Bank collapsed four years ago. And now, as then, credit spreads between triple-A companies and less creditworthy ones are diverging--a sign that weaker players can't get credit and might fail.

Still, the comparison goes only so far. Goldman, Sachs & Co. economist Testufumi Yamakawa counters that the government is far better prepared now to handle any bank failures. The deposit-insurance scheme is far better capitalized, and some $112 billion is already committed to pump money into banks that run into trouble. If more were needed, the Deposit Insurance Corp. could sell special-purpose bonds to the Bank of Japan, and perhaps some big institutional investors such as life insurers. That way the government wouldn't have to issue more debt itself and risk a bond-market crash.

So a bank failure or two "wouldn't translate into systemic risk," Yamakawa concludes. What's more, while small credit co-ops are dropping like flies--some 46 failed in 2001 alone, notes HSBC Securities Inc. bank analyst J. Brian Waterhouse--deposits are actually rising at the big Tokyo money-center banks. The real crisis is at the tiny thrifts, which hold just 13% of all deposits. A headache, for sure, but scarcely a big threat to the global financial system. Of course, the big banks still have to deal with some $600 billion in bad debt--but there's no immediate sign that the bad-debt problem, horrendous as it is, is about to get dramatically worse.

A FREE-FALLING YEN. For other doomsayers, a collapse in the yen will be the precipitating cause. The current round of yen depreciation--attributed to jawboning by Japanese bureaucrats and a blas? attitude by the Bush Administration--could get out of hand. A "sell yen" mentality among traders expecting a weaker currency could trigger a vicious cycle.

In response, Japan's biggest trading partners, such as South Korea and China, will either lose export growth or let their own currencies depreciate. Either way, Asia will stagnate, and even a boost to Japanese exports wouldn't offset the hit to corporate earnings at home, a stock-market blowout, and an intensifying banking crisis.

However, the risk of a yen collapse has faded. First, Treasury Secretary Paul H. O'Neill stated bluntly on Jan. 23 in Tokyo that the manipulation of exchange rates "can't improve productivity or fix nonperforming-loan problems." In other words, the U.S. won't tolerate an all-out attempt by the Japanese to drive the yen down. That should give bears some pause. Also, the latest capital-flow figures, for early January, show a net inflow of $12 billion into stocks and bonds. If those flows keep up, a floor will be built under the currency. Not exactly reason to panic.

DEFLATION AND DEBT. This is the threat to be dreaded most. On Jan. 24, the government reported that consumer prices fell 1.2% in December year-on-year, extending a deflationary spiral that has been going on for several years. The last time that happened in a major industrialized country, Herbert Hoover was President of the U.S.

Falling prices sound wonderful in theory, but they're devastating for a weak economy such as Japan's. They annihilate corporate earnings. They discourage consumers from spending if they feel prices might be even lower tomorrow. And they feed into the banking crisis by further depressing the price of land held as collateral by big banks and increasing the debt load in real terms for Corporate Japan. Average Japanese are feeling the real value of their debt rise, too. That's why the Japanese with mortgage loans are the ones who have cut back on their spending the most, notes Nikko Salomon Smith Barney economist Jeffrey D. Young.

The deflation threat is the one Japanese conundrum that few analysts try to argue is overblown. What's more, nobody seems to have a good idea of how to halt the trend. The Bank of Japan is already pumping massive liquidity into the banking system--a classic way to kick-start lending. But Japan's overcautious lenders don't want to turn that liquidity into loans. In any case, there is simply no credit demand. Some policymakers want to take radical measures to spark inflation by having the Bank of Japan print yen to buy everything from Japanese bonds to real estate, which the central bank would then hold onto. The result, theoretically, would be a rise in prices across the board. But that stratagem could backfire, because it might signal to bond investors that Japan has lost what little financial discipline it had left.

With any luck, a near-term financial eruption set off by the banks or a plummeting yen won't come to pass. A deflationary spiral, however, could cause a slow-motion collapse. To break out of that cycle, Japan needs economic growth, but Finance Minister Masajuro Shiokawa estimates that it will take until 2005 for the country to finally start growing again at a steady 1% to 2% annual rate. That means it will be some time before Japan starts carrying its weight in a world economy that needs all the growth, income, and jobs it can get right now. Bureau Chief Bremner covers finance from Tokyo.

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