Japanese banks crisis in twilight zone

Is Japan the land of the setting sun? COLIN DONALD weighs the economic evidence.

TOKYO - Does the long-predicted "spring meltdown" in Japan's banking system spell catharsis or catastrophe?

Tokyo's economic plight has become so deep and convoluted that debate has entered a weird black hole of warped perceptions. Bad news on the banks is welcomed for its potential to spur remedial action

Meanwhile, long-advocated and intrinsically healthy accounting reforms are seen as ushering in doomsday, as their implementation will reveal the shocking dimensions of the problem - estimated at $600 billion to $1 trillion in non-performing loans. Exposing this against a background of deflation and a shrinking GDP threatens to accelerate a downward spiral without precedent in a developed country since the 1930s.

Combine these dilemmas with paralysing conflict in the policy-making apparatus and the result is a growing perception of Japan as "the land of the setting sun".

Prime Minister Junichiro Koizumi's own economic team gives contradictory signals on how to fix the banking mess. The only consensus seems to be that the banking laws due to take effect at the end of this month are potentially devastating.

Under the new rules, banks will be forced to value their stock holdings at their actual current value, as opposed to what they were worth at their height. In some cases this means showing losses of more than 1 1/4 times their operating profits. The losses are already history, but admitting to them could cause new problems if it prompts more depositors or investors to flee.

Although it has rallied significantly in the past fortnight, the Nikkei 225 index has almost quartered in value since 1990. The double whammy of loss of dividend income and revaluation of their assets means that banks may be forced to dump their shares in attempts to avoid outright collapse.

Doing so would collapse the stock market still further, eviscerating listed companies, making their bad bank loans even worse.

The second of this year end's ill-timed reforms revokes Government insurance on large deposits of over 10 million ($181,000). With banks in such trouble, major depositors have been pulling out their money in anticipation. Many depositors have kept their money in the system, simply spreading it around in 10 million instalments. Others have been buying gold for safety. The possibility of a run on the banks has removed what little flexibility the financial sector retained during the past 12 years of feeble growth.

In the early 90s, Tokyo was in denial, in the mid-1990s it nibbled at the problem by bailing out small lenders, and by the late 1990s was fighting to contain major collapses. The inadequacy of this response has baffled and frustrated the world, which has no higher hopes of Japan than avoidance of collapse.

What is the worst that can happen? John Makin, an economist at the American Enterprise Institute in Washington, has speculated that depositors could bring down one or two of the country's bigger banks. To prop up the rest, Tokyo will have to issue a huge amount in new Government bonds, boosting Government debt that already stands at around 140 per cent of GDP. Not only the Nikkei, but the bond market and the yen could collapse.

Such pessimism rests on apparent parallels with the 1997-98 crisis that led to the downfall of Yamaichi Securities and three big banks.

The yen has fallen 13 per cent since last September, and is now hovering at 129 to the US dollar, close to that of August 1998. Short selling has driven the Topix Bank index down 40 per cent since March, just over the low that ushered in the collapse of the Long Term Credit Bank and Nippon Credit Bank four years ago.

Optimists counter that Tokyo is now better prepared to handle bank failures, as the deposit insurance scheme is better capitalised and $112 billion is laid aside for banks that run into trouble. If more were needed, Deposit Insurance Corp could sell special-purpose bonds to the Bank of Japan and big institutional investors such as life insurers, saving the Government from the risk of issuing more debt and risking a bond market crash.

Panic over the banks distracts from a more insidious danger, that of ongoing deflation, which is slowly rotting away the world's second-largest economy. Consumers are discouraged from spending, as they expect prices to be lower tomorrow, and corporate earnings are swooning.

The banks suffer here as well, as deflation depresses the price of land held as collateral and increases the debt load in real terms.

With luck, Japan will escape financial disruption triggered by reform efforts, but while there is room for debate on the scale of the banks' problems, nobody is saying the deflation threat is overblown. To counter it, the Bank of Japan is pumping considerable liquidity into the banking system, but cautious lenders don't want to turn that into loans, and anyway, demand is weak.

If Japan does manage to muddle through its year-end crisis, it will have at last taken a significant step towards a long-overdue process of coming clean, the first step in successful (though much smaller-scale) banking rescues in the US and Scandinavia.