Fixing Japan May Break America
Kenichi Ohmae, formerly director of the Tokyo office
of McKinsey & Co., is Japan's leading management guru. He is author
most recently of The Invisible Continent (Harper Collins, 2000) about
the new economy in a borderless world.
Tokyo-The new prime minister of Japan, Junichiro
Koizumi, has pledged to make whatever changes necessary to get Japan moving
again and clean up its financial mess, no matter how painful. This is
what United States President George Bush has said he wants. But if Koizumi
succeeds in fixing Japan, he may break the US economy in the process.
President Bush has prevailed upon Japan to attack the Japanese financial
mess swiftly and ruthlessly. Face up to the problems, he was told, bankrupt
insolvent companies and resolve the institutional debt problem.
Simple-right? In the isolated and protected environment of the old Keynesian
economy, this may have been an effective strategy that had little effect
on the rest of the world. A borderless and interlinked economy, however,
When Mori returned to Tokyo, his government began to implement policies
that Koizumi promises now to deepen-in effect, cutting support systems
once available to large financial companies in trouble.
Tokyo Life Insurance is a case in point. Tokyo Life enjoyed years of life
support from Daiwa Bank by having its over-collateralized, poor performing
loans continually rolled over despite failure to make principal repayments
for more than Þve years. If the ax falls on these bad loans, Tokyo
Life will go bankrupt. Daiwa Bank in turn will incur a huge financial
loss it has not provisions to cover.
Government statistics indicate that there are at least $1 trillion worth
of bad loans in the same category as Tokyo Life. To ''clean up'' this
financial mess would clearly have a devastating impact on Japan, but arguably
the problem would be more devastating for the US. To cover its financial
losses in its financial system as a whole, Japan will be forced to withdraw
the massive funds it has invested in the US to take advantage of higher
interest rates that have played a key part in propping up American prosperity.
There is little doubt that once President Bush witnesses the effects on
the United States of his recipe to cure Japan's ills, he will promptly
The Japanese Financial Crisis-The Bottom Line Problem | Most of the cause
of Japan's financial crisis lies with the incorrect classification of
debts and a subsequent and severe under-provision for bad and doubtful
lending. By law, Japanese financial institutions are required to classify
loans as follows:
class 4: Effectively bankrupt companies for which banks must provide
a 100 percent reserve (but not necessarily write off).
class 3: Companies in danger of bankruptcy for which banks must
provide a 75 percent reserve.
class 2: Non-performing (interest payments in default for more
than three months, which require a 50 percent reserve.
class 1: Low probability of default in which no reserves are required.
In drafting these provisions the government failed to assign clear definitions.
The wording uses ambiguous phrases such as ''needs attention,'' ''in danger
of bankruptcy'' and ''effectively bankrupt.'' Hence, individual banks
have had the discretion to classify and build reserves as they like, depending
on their interpretation of the law. Needless to say, non-performing loans
have been severely under-reserved.
Nearly 10 years ago the amount of failed loans were in the $2 trillion
range, primarily due to the sharp drop in Tokyo's land prices that fell
to only one-fifth of their 1989 peak value. The extent of the optimism
in the property markets and the incompetent lending practices of the financial
institutions during Tokyo's property boom are almost comical.
Over the last 10 years, we managed to clean up only $1 trillion of these
bad debts, so there is still another $1 trillion to go-and these, by definition,
are the hardest to clean up. Prompted by the enforcement of International
Accounting Standards (IAS) this year, for the first time in Japanese corporate
reporting history, assets and liabilities will have to be disclosed at
their fair market values. Some of Japan's best-kept secrets will be finally
AN HONEST REVIEW OF THE LAST DECADE
The US government, industry and individual American consumers have long
been the beneficiaries of Japan's instability. The loss of confidence
in Japanese financial institutions and in the Japanese economic system
drove Japanese institutional investors offshore-mostly into dollar-based
The capital flight out of Japan and into the United States was then accelerated
by the Clinton administration's ''economic advice'' to Japan to lower
interest rates, increase public spending and stimulate domestic demand.
The Japanese government yielded to these demands rather than implement
policies to promote capital coming home to Japan to solve its own financial
problems. Japan minted more money to stimulate demand and kept interest
rates close to zero to prevent capital flight out of the US. The ''Greenspan
magic'' of widening the interest-rate gap between the two countries and
engineering market stability further encouraged capital influx to the
US, which in turn strengthened the dollar and inflated the US stock markets.
The extent of linkage between Japan and the US was well understood by
the Clinton-Greenspan team.
AN HONEST REVIEW OF THE EXISTING SITUATION Interestingly enough,
this savvy awareness of the interlinkage of the Japanese and American
economies does not seem to have transferred to the Bush administration.
Clinton's micromanagers knew well the potential dangers a real cleanup
of the Japanese financial institutions would have on the ''new economy''
of the United States.
If Koizumi succeeds in his fulfilling his promise of finally making change
in Japan, President Bush will get a stern wake-up call indeed.
America no longer enjoys the super liquidity it had until only recently.
Over the last year, the Nasdaq has deflated by 65 percent, which equates
to about a $4 trillion loss. Some 80 percent of Americans have investments
in the stock market, either directly or through mutual funds or through
their pension funds. Yet, consumer debt is very high because spending
was fueled over the years both economically and psychologically by the
handsome growth of their assets.
Asset deflation of this magnitude for the average American is thus very
painful. In fact, it dwarfs Bush's $1.6 trillion 10-year-long tax-cut
campaign promise. It is no wonder that the American consumer has not reacted
well to the tax-cut proposal or Greenspan's recent interest-rate manipulations.
It is against this background that Japan must digest its remaining $1
trillion in bad credit. Since the entire Japanese GDP is only $5 trillion
and tax revenues are only $0.5 trillion, there is simply no way it can
do that without Japanese financial institutions pulling their money out
of the US.
Inevitably there will have to be a huge capital exodus, a homecoming of
the Japanese money that has been tied up for 10-plus years, financing
the US budget deficit. The result? The US economy will experience a liquidity
crunch, and both the Japanese and US economies will decline further.
I predict that Wall Street investors will escape and take money out of
their home country without hesitation put it into, for example, euro-denominated
securities. This in turn will prompt the dollar to fall, accelerating
further capital flight out of the US.
AN END TO THE AMERICAN MAGIC?
The ''American magic'' over the last 10 years, though based in the vaunted
entrepreneurial culture, has been inflated by the gaps in stability and
interest rates with the rest of the world, particularly with Japan. The
necessary capital flight back to Japan will cause a major market correction
to adjust the economies to their equilibrium values.
This market correction will allow America to finally realize just how
much of its asset appreciation was due to support from the rest of the
world. Real asset values will be revealed.
I believe that the Dow will decrease by one-third from its peak. When
the Dow was 12,000, it would have been 8,000 without the influx of foreign
Who will suffer the most?
The capital flight back into Japan will be close to $550 billion, of which
$320 billion is in Treasury bonds. The Japanese hold approximately 10
percent of all outstanding US government securities-more than any other
The highly leveraged American consumer market is more vulnerable to a
slowdown than Japanese consumers who have not been as euphoric as their
stock-weighted American counterparts.
The Japanese are prepared for the worse possible case. Americans are not.
The Japanese consumer is comparatively resilient. Liquid household savings
are high and borrowings are low. Only 8 percent of Japanese households
invest in the stock market. So a market correction of the Nikkei has had
minimal effect on the average Japanese consumer.
Unemployment may go up due to a series of corporate insolvencies, but
an increase from 4.9 percent to a two-digit level will not cause panic.
The tradition of Japanese households is to look after each other, covering
at least three generations in a household.
The pinch, however, will be felt multiple times over by Japanese financial
institutions. Among other losses, institutions will have to book significant
foreign exchange losses as the yen/dollar exchange rate has moved from
235 to 125 since US-denominated bonds were originally purchased in the
early 1980s. Once capital flight occurs, the dollar will further decrease,
causing even larger foreign exchange losses. This will not defer the capital
exodus as liquidity will be a far more important issue than currency losses.
Forty-five percent of stocks traded on the Nikkei are held by Japanese
financial institutions and closely held corporate groups. Their balance
sheets will continue to hurt as the Nikkei corrects to its real value-from
a 10-year high of 38,000 to, say, 9,000.
All this will happen sooner rather than later, and in just as much haste
Bush will change his orders and reissue a command to Japan's leaders to
put the brakes on change just as Clinton did. One big difference will
be that Greenspan will probably go to the Congress to blame US instability
on the Japanese depression, never mentioning that it was Japan that subsidized
the long American euphoria that has now come to an end.
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