Japan - Standing at the Crossroads

By Scott B. MacDonald

Japan had a difficult year in 2001. The economy again fell into a recession, unemployment rose above 5% and the financial sector remained problematic. The Koizumi government’s reform program inched forward, but still faced considerable resistance from part of the country’s political elite and entrenched interests. Unfortunately the reform effort comes at a time when the global economy has slid into a recession and the export sector, long the engine of growth for the Japanese economy, is feeling the chill effects of the U.S. slowdown. The dual nature of the Japanese economy — an efficient export sector and a protected, heavily indebted and inefficient domestic sector built around construction, retail and agriculture — has run out of gas. Exports were also hurt by a strong yen. We concur with the Bank of Japan’s increasingly bearish outlook for the economy and expect real GDP will contract next year. Sadly, the words of Mark Fields, president of Mazda Motors, ring true: "The only way Japan looks good is if you turn the charts upside down."

Forecasts for real GDP growth vary for Japan. The Economist’s poll of major economists puts 2001’s real GDP growth rate at —0.5%, with —0.4% for 2002. The IMF is looking at —0.9% in 2001, followed by an even steeper 1.3% contraction in 2002. The OECD is equally gloomy as it expects the Japanese economy will shrink until 2003. It also believes the recession could deepen if Tokyo fails to keep markets convinced that it is serious about reining in public debt or dithers on banking sector cleanup. Even Prime Minister Junichiro Koizumi expects the economy to be in recession for the next two years. Prospects for Japan are looking dimmer with the rating agencies. Not to be left out, Moody’s, Standard & Poor's and Fitch have bearish outlooks for Japan and have been active in downgrading the country’s ratings, citing slowness of economic reform, the large and growing public sector debt (130% of GDP), and questions over political will to carry reform ahead.

Next year could be a turning point for Koizumi and his efforts to reform the economy. The Japanese leader and his team are keenly aware of what ails Japan — the mounds of bad loans clogging the banking system, the pressing need for a rigorous banking sector cleanup, fiscal consolidation, and corporate restructuring. The protection for the highly uncompetitive domestic sectors must be ended and the broad reach of the state in the economy must be reduced through privatization and deregulation. While being aware of the problems and having formulated plans to deal with those problems are positive steps forward, implementation remains a critical and as-of-yet unfulfilled step. Rising concern about the troubled nature of the Japanese economy and in particular its banks, is part of the reason that the International Monetary Fund is sending a team to Tokyo to assess the level of bad loans.

While progress has been made in shifting banking assets into the hands of investors, including Ripplewood’s acquisition of the former Long Terms Credit Bank into what is now called Shinsei Bank and WLR’s purchase of the Kofuku Bank in Osaka, major concerns remain. Major Japanese banks reported losses for the semi-fiscal year ended 9/30/01 and on a consolidated basis, the eight major banking organizations (encompassing 15 banks) posted losses totaling ¥607 billion ($5.1 billion). The chief culprits were aggregate loan write-offs of ¥2.2 trillion ($18.3 billion) and unrealized losses on shares owned of ¥1.4 trillion. Only Sumitomo Mitsui and Sumitomo Trust recorded a net profit. Mizuho Holdings, one of the world’s largest banks in terms of asset size, announced a loss of ¥265 billion ($2.2 billion). Moreover, it expects to lose a substantial ¥720 billion ($6 billion) for the full fiscal year which ends on 3/31/02. Considering the grim banking environment, none of the banking groups will be paying a common dividend for the six-month period.

Looking ahead, Japanese banks must also consider the deepening nature of the recession, which will put many companies under pressure on their loan repayments. Consequently, Japanese banks are forecasting a combined loss for the full year ending 3/31/02 of almost Y2.3 trillion ($19.1 billion). Total non-performing loans for the eight banking groups stood at ¥20.7 trillion ($173 billion) at 9/30/01, up from ¥17.6 trillion at 3/31/01.

One of the clouds over the banking sector is a list of 66 companies whose financial position is similar to Mycal, a major retailer that went bankrupt in September. Prior to its collapse, Mycal was rated a Category 2 borrower (according to criteria used by the Financial Services Agency), which meant requiring attention, but well above Category 5, which is bankruptcy. The list was compiled by Toyo Keizai, a respected economic magazine in Japan and includes such companies as Nissho Iwai, Isuzu Motors, Tokyu Department Store, and two construction companies, Hazama and Kumagai Gumi. Needless to say, the list has caused a stir in corporate Japan.

However, having introduced many of the measures and processes needed to facilitate the bankruptcy process, Japan is now better equipped to undertake the restructuring necessary to enhance corporate restructuring and rationalization. Understandably, substantial reluctance remains to the dislocation that is an unfortunate byproduct of this transition. Nevertheless, having been given the tools, it is now essential that Japanese firms and financial institutions begin to embrace the painful steps that will ultimately serve to enhance their long-term competitiveness and profitability.

One of the major battles likely to continue into 2002 is over the reform of public sector institutions. Earlier in 2001, the Prime Minister stated that the Housing Loan Corporation was to be abolished and other state-owned financial institutions would be merged. His team also sought to freeze an expressway construction planned by the Japan Highway Public Corp. Opposition within the Prime Minister’s own Liberal Democratic Party, however, gutted his proposal to halt the highway project and watered down the public sector reform bill, arguing that the corporations in question are indispensable to stimulate the economy and serve the needs of the regional areas. Although the watering down of the reforms was a setback for the Prime Minister, the issues raised are not going away and it is likely that Mr. Koizumi will revisit them again in 2002.

Another major battle in 2002 will be the budget. Prime Minister Koizumi announced in December that he will seek to make a record cut in spending for fiscal year 2002-2003. In an outline released by the Finance Ministry, the government will seek to cut general spending, which excludes debt payment costs and subsidies to local governments, by 2.3% to Y47.6 trillion ($371 billion) for the year starting in April 2002. If passed in the Diet, this will be the first reduction in four years and the largest ever. According to the Finance Ministry, public sector debt will climb to Y693 trillion, equal to 139.6% of GDP, by March 2002. That would be the highest among OECD membership, even above Italy, long the organization’s major debtor country. Key elements of Koizumi’s plan are to slash the public-works budget by 10.7% along with a cut of 10.4% of aid to poor nations. Moreover, the Prime Minister has repeatedly indicated that he will stick to the cap for new government bond sales at Y30 trillion. The budget plan will be submitted to the Diet in January, where no doubt it will be the center of another battle between reformers and anti-reformers. Clearly Kazuyuki Tazawa, a senior economist at Sumitomo Mutual Life Research Institute, has captured the importance of the upcoming battle: "If Koizumi scraps the bond cap, requests for pump-priming spending will explode, and things will get out of control."

While much of the economic landscape is stark, the corporate sector is in the process of restructuring. In many regards it has no other option as it is increasingly more difficult for the government to provide bailouts and public opinion is generally opposed. The steel sector is already in the process of consolidation. A planned merger of Kawasaki Steel and NKK is set for April 2003, while Nippon Steel has moved to secure its position within the industry, recently inking partnership arrangements with Sumitomo Metal Industries as well as Kobe Steel. Although the short-term prospects for the Japanese steel sector cannot be called robust, the trend is to consolidate the "Big Five" into two major groups, which should bring some advantages in finding greater cost efficiency of operations. This trend is evident in other sectors and holds some degree of hope for the future, though the process is proving to be slow.
The Koizumi administration came into office with high expectations. Those expectations have only partially been met and the economic situation is eroding. The yen looks set to weaken into 2002, probably past the Y130 to the US $, possibly as far as to Y150. However, the yen’s weakening is not likely to resolve Japan’s problems and could complicate Tokyo’s relations with its neighbors. The same is true for the eventual U.S. recovery. While a pickup in the U.S. economy will help the export sector and mitigate the harshness of the downturn, the length of the downturn is dependent on the ability of Koizumi to steer reforms through the Diet and the private sector to further embrace restructuring. Without these two developments, the prognosis for Japan is going to be worse. In January 2002 the Koizumi government presents its budget to the Diet. This is the next big battle for the future of Japan and much is at stake.

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Editor: Dr. Scott B. MacDonald, Sr. Consultant

Deputy Editor: Dr. Jonathan Lemco, Director and Sr. Consultant

Associate Editors: Robert Windorf, Darin Feldman

Publisher: Keith W. Rabin, President

Web Design: Michael Feldman, Sr. Consultant

Contributing Writers to this Edition: Scott B. MacDonald, Keith W. Rabin, Uwe Bott, Jonathan Lemco, Jim Johnson, Andrew Novo, Joe Moroney, Russell Smith, and Jon Hartzell

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