Non-performing Loans and Deflation in the Japanese Economy
Toyoo GYOHTEN (President, Institute for International Monetary Affairs)
Slowdown of U.S. Recovery and Its Effect on Japan
Before we examine the current problems of the Japanese economy in general and of its financial system in particular, we need to consider the present state of U.S. economic recovery, because it has significant impact on Japan's economy. In my view, the U.S. recovery seems to be much weaker and take much longer than previously anticipated. There are at least three reasons for this.
First, it is well known that private consumption and housing investment have been supporting the U.S. economy despite a weakness in the corporate sector since the bursting of the IT bubble, but they are finally losing their steam because people are now worried about the sharp decline in the stock market, the high level of unemployment and the possible bursting of the housing bubble.
Second, the Enron incident and other corporate scandals have done a great deal of damage to the confidence of consumers and investors in the U.S. Also the corporate reform law, which is supposed to regain their confidence, has turned out to be so stringent that it is now hurting the morale of corporate managers and foreign investors.
Third, people do not like uncertainties due to possible U.S. attacks on Iraq. While a war might help the economy recover, as has often been the case in the past, it could hurt if it raises the interest rate and/or oil prices. In any case, uncertainties surrounding Iraq seem to be having a depressing effect on the U.S. economy.
These short-term risks as well as a longer term need to correct the U.S. current balance deficit will inevitably lead to decreases in U.S. imports from other countries, especially from Japan. This would mean that Japan could no longer reply on external demand for its economy recovery, as has been the case since this spring.
Difficulties in Dealing with Non-Performing Loans
This situation is posing a big challenge to the Japanese economy, because Japan is expected to deal with the non-performing loan problem and other structural problems while achieving an economic recovery despite deflationary pressure at home and from abroad. In my view, however, an economic recovery can and should be achieved simultaneously with structural reform. We have to do both at the same time.
The biggest issue here is how to dispose of non-performing loans in the banking sector. There are a number of difficulties that we are now facing to deal with this problem. First, the general public's allergy to the use of public funds has been developed since the mishandling of the "jusen problem" in 1995-96. Second, banks themselves are reluctant to accept the structural reform approach with the use of public funds, because they are not taking this problem seriously enough and are simply waiting for the economy to recover and for their bad loans to go away. Third, a number of large borrowers with huge debts are resisting bankruptcy even they should not stay in the market, and their main banks are trying to avoid any trouble associated with the bankruptcies of large borrowers.
As a result, non-performing loans have been increasing rather than decreasing over several years, and banks have not been able to increase their loans despite the Bank of Japan's policy of quantitative easing of money supply. Therefore, deflation continues and there are no signs of inflation. More and more people have begun to realize that there is no choice but to dispose of non-performing loans in order to recover from the depressed state of the economy.
It is regrettable that this is exactly what U.S. policy makers have been telling us all along. Once again, U.S. advice has moved the Japanese government in the right direction. Since the bursting of the bubble in Japan, U.S. financial authorities and specialists have been insisting that Japan must do the following three things: (1) injection of public funds to clean up non-performing loans, (2) drastic restructuring of financial institutions, and (3) structural adjustment of corporations that have borrowed too much. I reluctantly admit that their position has turned out to be correct after all.
How to Inject Public Funds
To inject public funds we can make use of the RCC (Resolution and Collection Corporation), for example, to purchase non-performing loans from banks at their book values. However, that can only be done on the condition that banks submit a restructuring plan, which should lead to the structural reform of the banking sector, and public funds may be used to compensate for the difference between the book values of bad loans at the time of purchase and their market values at the time of sale in the future.
Or alternatively, banks' assets should be reevaluated more rigorously, and more allowances should be made to match the increased amount of non-performing loans as a result of reevaluation. If banks' capital becomes insufficient in this process, managers and stockholders must pay their price before public funds are injected to boost banks' capital.
Which is better is a matter of choice. It depends on the situation that individual banks are in. Direct injection of public funds into the banking sector is more straightforward than through the RCC, but it might be rather difficult to reevaluate banks' assets and also to force bank managers and stockholders to accept their responsibilities.
Necessity of Anti-Deflation Policy and Deregulation
The problem is that deflation is not going to go away easily, even if public funds are injected either way. An ideal scenario is that at least the existing non-performing loans are taken care of by using public funds in such a way that market trust is regained, and then the overall atmosphere for the economy would improve and the prices of bank stocks might well go up.
Of course, a temporary confusion might be inevitable if the structural adjustment of borrowers is rigorously pursued. However, such an adjustment should contribute to more efficient use of labor, capital and technology. Anti-deflation policies would, therefore, include tax changes to facilitate such an adjustment in the market for example. Also, conditions for unemployment insurance and retraining should be improved.
In addition, we need to do away with unnecessary regulations to encourage new businesses to emerge in such fields as medical care, transportation, telecommunications and distribution. The proposed measure of setting up special zones for deregulation seems to be a good idea if it actually is implemented.
There is no assurance that the accelerated disposition of non-performing loans, together with anti-deflation policy, would lead to Japan's economic recovery, especially when the world economy is in trouble. But that might be the only way to prevent the Japanese economy from spiraling down without limit.