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- WSJ.com Major Business News February 14, 2002 COMMENTARY Winners and Losers In a Japan Bank Bailout By DAVID ROCHE It's not just Japan's banks and their corporate clients that are going bust. The state is also in a perilous financial position, with gross government debt now standing at just under 140% of gross domestic product. That's the highest of any Organization for Economic Cooperation and Development country and more than 35% higher than the next most indebted G7 government, Italy. Nor is that the end to the extent of the public sector's liabilities. There are hidden debts in local government and in all the Special Public Corporations that have been set up over the last few decades to finance all sorts of pork barrel projects that the ruling political elite lobbied for to keep their constituents happy. Only their constituents aren't so happy when they look around and see their taxes wasted on unfinished bridges and roads, etc. And then there are pensions that the government will have to pay out over the next few decades as Japan's senior citizens keep growing in numbers. Pension funds are hugely underfunded for this task. Adding up all this puts Japan's public debt at well over 300% of GDP. Simply to stabilize this mounting burden of public debt to GDP, the government should be running a primary budget surplus of 5% of GDP before the cost of debt servicing. But instead it is currently running a deficit of around the same proportion. With tax revenues set to stagnate in a depressed economy, there is no realistic prospect of achieving the necessary surplus, since this would involve the politically impossible step of cutting government spending by 10-12% of GDP. So the Japanese government is not well placed to bail out the banks, as reports suggest it is about to do, under the new anti-deflation plan that Prime Minister Junichiro Koizumi has directed his cabinet to draw up. That is not to deny the extent of the banking sector's difficulties. Official estimates from the Financial Services Agency put non-performing and troubled loans at 150 trillion yen ($1.12 trillion), or about 30% of GDP. But even that is probably an underestimate -- the total size of bank bad debts is more likely to amount to closer to 180 trillion yen, or 40% of GDP. On top of this, the banks have been building up significant losses on their equity holdings as the Topix Index, a capital-weighted measure of share prices, hits an 18-year low and they are forced to mark down these assets to market prices in their accounts. Given the size of the problem, the banks cannot be left to stew. Reform must come, either by choice or under the threat of a systemic crisis. But bailing out the banks with injections of public money would drive a coach and horses through Mr. Koizumi's commitment to fiscal probity. It would also make nonsense of his promise to cap the issuance of new government bonds to pay for budget deficits at 30 trillion yen, or about 6% of GDP. Nor is it a viable option to write off these debts and let the banks' corporate clients die, as this would destroy economic activity and drive up unemployment. GDP would probably contract by a further 1.5-2.0 percentage points, while it would add another 4% to the already record unemployment rate of 5.6%. A further consideration against such a step is that it would put at risk the wealth of the average Japanese household. While net household wealth in Japan is similar to that in the United States -- at about 440% of GDP -- the difference is that Japan's savers have most of their assets deposited in banks. These in turn have these invested savings in loss-making companies, collapsing stocks and hugely overpriced government bonds. In contrast, American households save hardly anything, but have invested effectively in the equity of a dynamic corporate sector and rising real estate values. So here is the dilemma for Japan. If the government cleanses the banking system and restructures the mountain of fake assets, it will also destroy Japanese household savings in the process. If that looked like it was happening, Japanese citizens would get their money out of the banks as fast as they could. Indeed there are already signs of depositors shifting their savings into more accessible current accounts and cash into gold. If that ever developed into a full-scale run on deposits it would bring the banking system crashing down anyway. Of course, the politicians could do an Argentina and put a freeze on withdrawals. But this would amount to a straight confiscation of household wealth and so is a step any politician who wants to survive would not contemplate. But there is another way out. The government could bail out the banks and protect citizens' deposits, not with real money, but with funny money instead. In other words, the Bank of Japan could simply print enough yen to cover the government deficit, in the knowledge that this would drive down its value against other currencies and gold. That need not lead to a capital flight out of the country. Although the yen is already slipping in anticipation of such a step, there is no sign of such an exodus so far. Overseas payments data reveal that the sale and purchases of foreign currency assets remain broadly in balance. Japanese households are actually being rational. They know the government will never confiscate their deposits -- whether bank deposit guarantees are capped or not. And in an economy where prices are falling at 2% a year, keeping their savings as bank deposits means they are picking up a real return of 2.5% a year. Moreover it is not true that printing money is always inflationary. To bail out the banks by printing money would drive the yen down to 160 to the dollar, or possibly even further. But would it also fuel inflation so that the real value of households' deposits was destroyed? Probably not, because Japan -- like the rest of Asia -- is currently in a chronic oversupply situation, which means businesses are in no position to pass on price increases. And, driven by the forces of globalization, Japan is also in the middle of bringing its absurdly high price levels down to world levels. The second reason that printing money to fund a bailout won't fuel inflation is that the banks wouldn't be lending the money -- instead they would just put it straight into Japanese government bonds. So there would be no money multiplier effect, and printing more money for this purpose wouldn't create the demand that could drive inflation. So in a bank bailout, the losers are likely to be those Japanese who travel abroad or owe foreign debts. It won't be the average depositor. Japan would have a bailout at the expense of its currency -- not the value of household savings. Mr. Roche is founder of Independent Strategy, a London-based market strategist. URL for this article: http://online.wsj.com/article/0,,SB1013648663376052920.djm,00.html Updated February 14, 2002 12:01 a.m. EST Copyright 2002 Dow Jones & Company, Inc. All Rights Reserved Printing, distribution, and use of this material is governed by your Subscription agreement and Copyright laws. For information about subscribing go to http://www.wsj.com

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