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By Scott B. MacDonald

Japanese Banks – And Now Comes the Hard Part: The most recent earnings season for Japanese banks was the best in years. Helped by an economic rebound, a higher Nikkei, and sustained pressure by the government to clean up bad loans, the major banks (with the notable exception of UFJ) posted solid earnings. Now comes the hard part. As the banks look into the current fiscal year that ends March 31, 2005, they have to find ways to make money. That is going to be a challenge. Lending alone will not provide a platform for the generation of strong profits. While loans to small and medium-sized companies and individuals through credit cards are rising, total lending fell each month since the Bank of Japan began tracking the figures in January 2001.

There are three reasons for the decline in bank lending and the ongoing difficult nature of the market. First, auto, electronics and other manufacturing companies are cutting their borrowings as they move production to China to reduce costs. Second, utilities are slashing expenditures on new units to prepare for greater competition in the domestic energy markets. Third, most of Japan’s top corporations, with investment grade ratings, are seeking fewer loans. Instead many of these companies are tapping stock and bond markets in Japan. They are also willing to tap foreign bond markets for cheaper funds. The impact of all three trends is to reduce loan demand and credit spreads, while loan margins are shrinking due to competition.

What is the solution for Japanese banks? The answer is a greater movement into investment banking and other fee-advisory services. The banks can also charge the borrowers more, though may only accelerate the shift into non-bank finance venues. U.S. banks have long made the shift to offering non-lending fee income driven business. Almost 32% of Citigroup’s record $5.27 billion net income for Q1 2004 came from its global investment banking business, while half of the profit came from its global consumer finance unit, including credit card operations. In contrast, two-thirds of Mizuho’s year-end 2004 gross profit was generated from its lending business, while non-bank fee income was only 13%. The weakness in the fee income side of the business is evident by the following: Mizuho ranks 8th in equities underwriting, 10th in local mergers & acquisitions advising and 3rd in bonds underwriting.

March 31, 2005 is still far in the distance. Most major Japanese banks are still enjoying the success of last year. However, the path forward is going to be very challenging. Japanese banks have considerable work ahead of them. Although non-performing loans have fallen, they remain an issue. In addition, the pace of economic growth could slow, making the business environment more difficult. Consequently, we think that Japanese banks are making a lot of progress, but making good profits in the year ahead is going to be even more challenging.

Pension Reform Ruckus: In early June, opposition lawmakers attempted to pull a ruling Liberal Democratic party (LDP) legislator from a podium in the Diet to prevent him from announcing the passage of a bill seeking to reform Japan's troubled pension system. Despite the effort on the part of the opposition members of the Diet, committee head Masayuki Kunii managed to announce the bill had been approved by a majority in the upper house committee. Pension reform has been a heated issue in Japan as the government is proposing to cut benefits and raise premiums. Adding tension to the issue, a number of Japanese politicians confessed to missing pension premium payments, including Prime Minister Koizumi and one-third of his Cabinet. In addition, two top politicians stepped down from their posts after it was revealed they had also skipped pension payments in the past. Katsuya Okada, head of Japan's largest opposition Democratic Party, pledged to try to block the legislation at all costs. Committee approval clears the way for the bill to be enacted into law by the full chamber, where Koizumi's LDP and coalition partner New Komeito, enjoy a majority.

The Diet has been debating how to save the pension system from insolvency, which is set to become a major election issue in the July contest for the upper house of the Diet. Japan's society is rapidly aging and many are apprehensive the smaller work force of the future will not generate a high enough level of premium payments to supply pensions to the growing ranks of retired people.

North Korea – New Talks Scheduled: A new round of six-nation talks seeking to end North Korea's nuclear weapons programs will commence in Beijing on June 23. The third round of six-nation talks will be preceded by two days of preliminary negotiations involving lower-level officials. Two previous rounds of high-level talks ended without any breakthroughs in settling the standoff, which flared in October 2002 when the United States said North Korea admitted operating a secret nuclear program in violation of a 1994 agreement. Washington and its allies have been attempting to arrange a new round of six-nation talks also involving the two Koreas, host China, Japan and Russia by July, which was agreed on by the nations when they last met in Beijing in February. After the second round in February, the six nations held their first lower-level meeting last month. The so called "working group" discussions are envisioned as trying to smooth the way and create an agenda for a third round of high-level negotiations.